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VOLUME 15, NUMBER 1, FALL 1979 

THE 

INTERNATIONAL 

JOURNAL OF 

ACCOUNTING 

EDUCATION AND RESEARCH 



UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN 



CENTER FOR INTERNATIONAL EDUCATION AND RESEARCH 
IN ACCOUNTING OF THE COLLEGE OF COMMERCE 
AND BUSINESS ADMINISTRATION 

The Center for International Education and Research in 
Accounting was established to foster the international devel- 
opment of education and research in the accounting discipline, 
to provide a base for the international exchange of ideas and 
materials relating to accounting education, to encourage and 
assist both accounting faculty personnel and students from 
other countries to come to the University of Illinois at Urbana- 
Champaign for study and research in accounting, and to pro- 
vide faculty members for assignment to universities in other 
countries. 

The center, functionally and administratively, is a constituent 
part of the Department of Accountancy and the College of 
Commerce and Business Administration of the University of 
Illinois at Urbana-Champaign. The graduate training of a sub- 
stantial number of international students has been an impor- 
tant activity of the department for many years. 

One of the specific goals of the center is the publication of 
reports, booklets, and monographs which further the cause of 
advanced education and research in accounting. 

V. K. Zimmerman, Director 



The person charging this material is re- 
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Latest Date stamped below. 

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for disciplinary action and may result in dismissal from 
the University. 
To renew call Telephone Center, 333-8400 

UNIVERSITY OF ILLINOIS LIBRARY AT URBANA-CHAMPAIGN 



JAN Z 2 «a 



t 




THE 
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ITING 

ID RESEARCH 



L161— O-1096 



Volume 15 ■ Number 1 ■ Fall 1979 

CENTER FOR INTERNATIONAL EDUCATION AND RESEARCH IN ACCOUNTING 
UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN 

© 1980 by the Board of Trustees of the University of Illinois 



The International Journal of Accounting Education and Re- 
search is published semiannually, spring and fall, by the 
Center for International Education and Research in Account- 
ing, College of Commerce and Business Administration, Uni- 
versity of Illinois at Urbana-Champaign. Subscription rates 
are $10.00 per year. Single-copy price is $5.00. Copies of prior 
issues are still available. 

Manuscripts and communications for the editor and business 
correspondence should be addressed to The International 
Journal of Accounting Education and Research, 320 Com- 
merce Building (West), University of Illinois at Urbana- 
Champaign, Urbana, Illinois 61801. 

V. K. Zimmerman, Editor 
JaNoel S. Lowe, Assistant Editor 



V. 



Contents 



ST. LOUIS TO MUNICH: THE ODYSSEY OF THE INTERNATIONAL 
CONGRESSES OF ACCOUNTANTS 

GERHARD G. MUELLER 

THE INTERNATIONAL FEDERATION OF ACCOUNTANTS: 
ITS ORGANIZATION AND GOALS 

MICHAEL N. CHETKOVICH 

THE INTERNATIONAL FEDERATION OF ACCOUNTANTS: OPERATING 
PROCEDURES AND CURRENT PROGRESS 

ROBERT N. SEMPIER 

SFAS NO. 8: CONFORMING, COPING, COMPLAINING, 
AND CORRECTING! 

THOMAS G. EVANS and WILLIAM R. FOLKS, JR. 

A NOTE ON TRANSLATION FOR INTERIM ACCOUNTS 

ANDREW G. PIPER 

ASEAN FEDERATION OF ACCOUNTANTS: A NEW INTERNATIONAL 
ACCOUNTING FORCE 

FREDERICK D. S. CHOI 

INTERNAL PERFORMANCE EVALUATION OF MULTINATIONAL 
ENTERPRISE OPERATIONS 

HELEN G. MORSICATO and LEE H. RADEBAUGH 

MULTINATIONAL ACCOUNTING: A TECHNICAL NOTE 

M. A. FEKRAT 

RECORDING AND CLASSIFYING TRANSACTIONS 
IN THE BALANCE OF PAYMENTS 

RITA M. MALDONADO 

A STUDY OF INTERNATIONAL ACCOUNTING EDUCATION 
IN THE UNITED STATES 

JANE O. BURNS 



A Note from the Editor 



This issue of The International Journal of Accounting Education and 
Research contains papers delivered at an International Seminar on 
Accounting held at the University of Illinois at Urbana-Champaign 
on March 29-31, 1979. The theme of the seminar was "International 
Accounting: Professional Organizational Efforts and Current Report- 
ing Problems." 

We are particularly pleased to publish this collection of the papers 
presented at the seminar. The seminar topic remains, in our opinion, 
an important and contemporary one. The expanding importance of 
accounting internationally is manifested in many ways. The growth of 
multinational corporations and the political and economic stipulations 
of national states to the practice of accounting are but two of these 
influences. Quite clearly, the development of accounting organizations 
concerned with the effective operation of the accounting profession 
internationally is an important related factor. 

The articles presented reported on international developments as 
of the time of the seminar. A number of the organizations mentioned 
have had new pronouncements. The reader should refer to the most 
recent publications of the international accounting associations men- 
tioned to determine the most recent developments. The significant in- 
ternational changes that relate importantly to the accounting profession 
are clear from a reading of the manuscripts. We believe the pace of 
this development will increase. 

In addition to the papers presented at the seminar, three additional 
manuscripts commenting on other international aspects of accounting 
are included in this issue. 

V. K. Zimmerman 
Urbana, Illinois 



St. Louis to Munich: The Odyssey 

of the International Congresses of Accountants 

GERHARD G. MUELLER* 



Odysseus (or Ulysses, as some translations have it) was of noble Greek 
lineage. He joined the high and mighty of his country to fight in the 
Trojan War. His return from that venture was more treacherous than 
the war itself; the poet speaks of blinding storms, mirages, siren songs, 
and hosts of false starts, dangers, and sunken ships. After a journey of 
more than ten years, he reached his home in Ithaca again. Tattered 
and emaciated as he was, no one recognized him except his loyal dog 
and a few old beggars on the street. Yet at his palace there was much 
action. Believing him to have perished some time before, countless 
suitors romanced his wife, Penelope. Still she had not given up hope 
and spent herself to near exhaustion defending his interests and main- 
taining his political rights. Not unexpectedly, the story has a positive 
ending. Odysseus is able to establish a new order in Ithaca and re- 
ensconce himself solidly as king of his domain. 

Why appeal to Homer to set the scene for the 1979 University of 
Illinois International Accounting Seminar? The parallels between the 
story of Odysseus and the internationalization of professional account- 
ing are many. 

The international heritage of accounting is a well recognized fact. 1 

* Gerhard G. Mueller is professor of accounting and director of the Graduate 
Professional Accounting Program at the Graduate School of Business Admin- 
istration at the University of Washington, Seattle. He is also the director of the 
International Accounting Studies Institute of that university. Dr. Mueller was 
Beta Gamma Sigma Distinguished Scholar for 1978-79. 

1 Robert H. Parker, "Some International Aspects of Accounting," Journal of 
Business Finance (Winter 1971): 29-39. 



2 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



After its procedural beginnings in the Italian city states during the 
thirteenth and fourteenth centuries, the "art of double-entry book- 
keeping" migrated north to Austria and Germany and from there to 
France and Holland. Soon the Hanseatic city states had financial re- 
porting systems superior to those of their Italian peers. And the French, 
of course, adapted the system to governmental record keeping and 
accounting. In all, an international success story had begun. 

Accounting's Trojan War, however, did not occur until the mid- 
nineteenth century, when professionalization began. Up to that point, 
accounting was strictly vocational in nature. Then the Scots saw 
opportunities for financial auditing undertaken by accounting profes- 
sionals. Soon other parts of the English-speaking world followed suit, 
and the accounting odyssey of international professionalism had its 
start. At the International Congress of Accountants in Munich in 
1977, it came to a good end. At that point, the International Federa- 
tion of Accountants (IFAC) was formally created. It marked wide- 
spread recognition of the fact that professional accounting is, indeed, 
international in scope and application. The end of the odyssey, how- 
ever, is not the subject of this paper. Our purpose here is to sketch 
the odyssey and summarize a few of the effects it has produced. 

THE INTERNATIONAL CONGRESSES OF ACCOUNTANTS 

Probably the most significant benchmark in the development of inter- 
national professionalism for accounting is the dogged adherence to 
providing an international forum for the exchange of thoughts and 
experiences. This forum took shape as the International Congresses of 
Accountants. They began in St. Louis in 1904 and at present are 
regularly scheduled events taking place five years apart. Organization 
and conduct of these congresses have withstood global wars and heights 
of economic boom and depression. Cultural, legal, political, and social 
inroads have not been able to sideline the International Congresses of 
Accountants. So we do have something in common with our Greek 
friend, Odysseus! 

The Munich Congress in 1977 was the eleventh in the series. Pro- 
ceedings were published for each Congress, and it is a most illuminating 
exercise to read through these eleven books. To set the scene somewhat, 
let us briefly review some of the concerns of the time by looking at the 
official records of four such gatherings. 

St. Louis, 1904 

Conducted during a world's fair, this first Congress was international 
in nature but did not have "international" in its title. It was held under 



Odyssey of International Congresses of Accountants 3 



the auspices of the "Federation of Societies of Public Accountants in 
the United States of America." Participants included such illustrious 
professional personalities as Arthur Lowes Dickinson, William M. Ly- 
brand, George O. May, and R. H. Montgomery. The Society of Ac- 
countants and Auditors in London sent an official delegate, as did the 
society's Scottish branch in Edinburgh. The Society of Incorporated 
Accountants and Auditors in Ireland sent its delegate with a formal 
resolution expressing its interest in the "professional welfare of all Irish- 
American accountants." 

Key topics of the Congress included one or more papers under each 
of the following general headings : 

1. Municipal Accounting; 

2. The CPA Movement and the Future of the Profession of the Public 
Accountant in the United States; 

3. Audit Companies; 

4. Duties of Professional Accountants in Connection with Invested 
Capital Both Prior to and Subsequent to the Investment ; 

5. The Importance of Uniform Practice in Determining the Profits of 
Public Service Corporations Where Municipalities Have the Power to 
Regulate Rates; 

6. The British Societies ; 

7. The Canadian Societies; 

8. The Profits of a Corporation ; and 

9. Public Accountants in Holland. 

New York, 1929 

Twenty-five years later, the Congress had become truly international in 
every respect. The list of "foreign participating societies represented 
at the Congress" included the following countries: Austria, Canada, 
Central America, Czechoslovakia, England, Germany, Ireland, Italy, 
Japan, Mexico, Norway, Puerto Rico, Rumania, Russia, Scotland, and 
Switzerland. Colonel Robert H. Montgomery was president of this 
Third International Congress of Accountants, with Professor Giles L. 
Courtney of New York University's School of Commerce serving as 
executive secretary. Prizes were awarded for papers, with the first prize 
in the amount of $500 going to Perry Mason. 

Session topics on which several papers were prepared included the 
following : 

1. Development of Professional Accounting in Europe; 

2. Legislation Affecting Accounting in Private Industry for Tax Pur- 
poses or in Mergers or Cartels; 



4 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



3. Educational Activity in Accounting and Statistical Work; 

4. Problems of Depreciation and Obsolescence; 

5. Principles of Valuation ; 

6. Consolidated Financial Statements; 

7. External Influences Affecting Accounting Practice; 

8. Cost Accounting; 

9. Municipal and Governmental Budgets; and 

10. The Thirteen-Month — Year Calendar Reform. 

Amsterdam, 1957 

The president of this five-day meeting was Mr. "International Ac- 
counting Practice" himself, the late Jacob Kraayenhof. Sizable dele- 
gations at this congress came from Australia, Austria, Belgium, Brazil, 
Burma, Canada, Ceylon, Denmark, East Africa, Finland, France, 
Ghana, Germany, Great Britain and Ireland, India, Israel, Italy, 
Japan, Luxembourg, Malta, Mexico, Monaco, New Zealand, Norway, 
Pakistan, the Philippines, Rhodesia, South Africa, Spain, Sweden, 
Switzerland, Thailand, Trinidad and Tobago, Turkey, the United 
States of America, and Venezuela. 

The professional sessions were organized under the following six 
general themes: 

1. Principles for the Accountant's Profession; 

2. Budgeting and the Corresponding Modernization of Accounting; 

3. The Verification of the Existence of Assets; 

4. Business Organization and the Public Accountant; 

5. The Internal Auditor; and 

6. Ascertainment of Profit in Business. 

Munich, 1977 

The size and involvement of the latest International Congress of Ac- 
countants literally "flooded" the entire city of Munich. 2 The plenary 
sessions, with their thousands of participants, had to be held at the 
Olympic Hall erected as part of the complex serving the prior Summer 
Olympic Games. Every city hotel was sold out, and even private dinner 
reservations were difficult to come by. Congress registration badges 
yielded free rides on municipal streetcars and buses and prompted 
consternation everywhere that "there are this many accountants 
around." 

The topics of the three major plenary meetings were these: 

2 Of the 6,323 people officially registered for the Munich conclave, 3,758 were 
Congress members and 2,565 were accompanying persons. 



Odyssey of International Congresses of Accountants 5 



1. Efforts toward Harmonization of Financial Reporting and Auditing 
over the Last Five Years; 

2. Essential Information in Published Annual Financial Statements; 
and 

3. Orientation of Financial Accounting, Planning, and Consulting for 
Purposes of Enterprise Management. 

Papers on technical subjects were organized around the following 
themes : 

1. Inflation Accounting; 

2. Accounting for Research and Development Costs; 

3. Accounting for Income Taxes; 

4. The Accountant as Consultant — Possibilities and Limits; 

5. Accounting for Intercorporate Investments (including the Equity 
Method) ; and 

6. Preparation, Exposure, Contents, and Acceptance of International 
Accounting Standards Issued by IASC. 

Survival Factors 

If the International Congresses of Accountants were indeed the key 
ingredient to the international "leavening" of our profession, it seems 
important to judge what factors contributed most importantly to the 
survival of these meetings. I render this judgment on the basis of close 
scrutiny of the proceedings of the eleven International Congresses and 
of personal attendance at the last four of them. 

As with most social institutions, people and their respective leader- 
ship abilities tend to "make or break them," so to speak. The two very 
remarkable "people" aspects of the International Congresses are that 
(1) each Congress drew into attendance many of the recognized pro- 
fessional leaders of the day, and (2) the same names appear time and 
again among attendee lists for three to five successive Congresses. 

Since World War II, many international CPA firms and associations 
have held partners or policy committee meetings in conjunction with 
the Congresses. This practice provided a certain subsidy on Congress 
attendance and insured that senior executives from the professional 
ranks became actively involved in the planning of Congress and the 
later conduct of technical and organizational meetings. So the recog- 
nized leaders of the profession have consistently had a major involve- 
ment in International Congress affairs. 

A second important element was surely the fact that Congress par- 
ticipants never took their professional and business concerns too seri- 



6 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ously. The president of the 1904 meeting, J. E. Sterrett, commented in 
his opening remarks: 

While the program contains much that is of a serious and sometimes techni- 
cal character, the committee has not forgotten that man is a social animal. 
The reception this evening, at which the Mayor of St. Louis has very kindly 
consented to be present, and the banquet tomorrow evening, both of which 
occasions are to be graced by the presence of the ladies, will afford oppor- 
tunities for us to become better acquainted and to forget for a little time 
"the cares that infest the day." 

For the same meeting, the official record shows that after a luncheon 
enjoyed by all present, "the members of the Congress hurried back to 
the hall," and, at the hall, the Congress was called back to order at 
3 : 30 p.m. There must have been some socializing as admonished by 
President Sterrett! 

The setting was not much different in 1929. Colonel Robert H. 
Montgomery, president of that Congress, stated during its opening 
session : 

This Congress is a grand free-for-all, checking-up party. We are proud 
only of what we accomplish when we can prove it to be good. . . . The dis- 
cussions must be critical, pertinent and constructive, or we will be bored. We 
ask to be entertained or instructed. A word to the wise is sufficient! 

It seems therefore that a low-key approach to these Congresses has 
helped them to survive. Their seemingly semi-social nature was clearly 
appealing to organizers and attendees alike. Cultural and artistic events 
always were scheduled portions of Congress activities. There have al- 
ways been formal receptions, banquets, and/or dinner dances. Highly 
placed political or civic personalities of the host countries have always 
addressed assembled Congress members. Quite apparently, the "all 
work and no play . . ." adage applies to accountants as much as to 
everyone else. 

A third characteristic, with sensitivity to Congress successes, appears 
to be the continuous ability of Congress program planners to evolve 
overall programs in tune with the moods and needs of the times. The 
birth pangs of the national professions and their respective organiza- 
tions were much in evidence in 1904. Technical adolescence was evi- 
dent in the 1929 program: valuation principles, cost accounting pro- 
cedures, consolidated financial statements, and budgetary processes. 
Internal controls and accounting for effects of inflation were the key 
program topics in 1957, and objectives of financial statements plus the 
international accounting standards issue dominated the 1977 gathering. 

In retrospect, the "mirror of the times" approach to Congress pro- 



Odyssey of International Congresses of Accountants 7 



grams apparently served everyone well. Some excellent papers are in 
evidence for each of the eleven venues. There can be little doubt that 
each participant was able to derive some benefit from the technical 
programs and "take home" some points and pointers useful for sub- 
sequent professional practice. One gets the impression that there were 
few, if any, persons who ever regretted attending one of the Interna- 
tional Congresses of Accountants. 

A fourth Congress dimension of note seems to reflect a certain en- 
trepreneurial spirit among professional accountants in different coun- 
tries. Time and again one finds references in papers, opening or closing 
addresses, and toasts presented at various occasions recognizing satis- 
faction in having learned what others are doing. Sharing of professional 
(including business development) experiences has, of course, two 
dimensions — willingness to share one's successes with others and the 
reciprocal interest in what others are doing and how they are accom- 
plishing it. Both of these aspects surface time and again in Congress 
proceedings. Accountants on these programs took pride, by and large, 
in relating individual or firm accomplishments. Equally important, 
their audiences appeared eager to listen and interested in learning. 
Thus, a certain spirit of professional enterprise endowed successive 
International Congresses of Accountants with take-home benefits for 
the attendees. These benefits, as pointed out in the various proceed- 
ings, accrued not only from technical sessions. Over and over again, 
they were achieved through informal interchanges that are the natural 
by-product of large-scale, relatively loosely structured international 
convention meetings. 

Finally, one comes away from reading the books of proceedings with 
an impression of an indomitable spirit of idealism unleashed through 
these professional gatherings. Literally from the beginning, the profes- 
sional accountants involved in these meetings reached for higher goals, 
better professional structures, and the best possible service to clients. 
Attention to international harmonization (in later years standardiza- 
tion) established itself from the beginning as a central purpose of these 
Congresses. And this idealism simply refused to die, even though it was 
subverted time and again by waves of political nationalism and over- 
doses of professional provincialism. Mr. Jacob Kraayenhof, president 
of the 1957 Amsterdam International Congress of Accountants, took 
the message of international standards to the 1959 annual meeting of 
the American Institute of CPAs by appealing to the goodwill and pro- 
fessional strength of the American members of the profession to foster 
the cause of international standards. It took another fourteen years 



8 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



(until 1973) for the International Accounting Standards Committee to 
open its portals, and another four years (until 1977) for the interna- 
tional odyssey to end in the formation of IFAC. Decades had already 
passed since the international standards movement had been launched 
in earnest! One must, therefore, acknowledge a characteristic of 
idealism and commitment to purpose as anchors in the Internationa] 
Congress of Accountants movement. 

LEVERAGE EFFECTS 

Not surprisingly, the consistent growth and visibility of successive 
International Congresses of Accountants spawned (1) a number of 
parallel international accounting meetings and conferences, and (2) 
a nucleus of international accounting panels and agencies. On the 
former, the influence was rather direct — on the latter, more indirect. 

The idea of separate international accounting conferences for the 
Western Hemisphere gained support quickly after World War II — in 
fact, before the International Congresses of Accountants sequence was 
revitalized for the post- World War II period with the Sixth Interna- 
tional Congress of Accountants held in London in 1952. The Western 
Hemisphere group organized itself as the Interamerican Accounting 
Conference and held its first hemisphere meeting in San Juan, Puerto 
Rico, in 1949. In 1975 the Interamerican Accounting Conference 
changed its name to Interamerican Accounting Association (IAA) to 
signal activities beyond periodic conferences. At present, IAA Secre- 
tariat headquarters are located in Mexico City at the premises of the 
Mexican Institute of Contadores Publicos. Among many other respon- 
sibilities, the Secretariat is instrumental in translating a large volume 
of English-language technical accounting literature into the Spanish 
language. It also publishes a quarterly newsletter for the entire Western 
Hemisphere profession. The Thirteenth Conference of the Interameri- 
can Accounting Association took place September 16-20, 1979, in 
Panama City. 

Also prior to the resumption of the International Congresses of 
Accountants in London in 1952, twelve professional associations of 
independent accountants from Austria, Belgium, France, West Ger- 
many, Italy, Luxembourg, the Netherlands, Portugal, Spain, and 
Switzerland founded the European Accountants Association (Union 
Europeenne des Experts Comptables, Economiques et Financiers — 
UEC) in November 1951 in Paris. The first formal Congress of this 
continental European group occurred in 1953 with partial sessions in 



Odyssey of International Congresses of Accountants 9 



Florence and Rome, Italy. The Eighth UEC Congress was held in 
1978 in Dublin, Ireland. 

UEC sponsors very technical accounting seminars (called Euro- 
seminars) , conducts study conferences, and supports an extensive pub- 
lications program, including an accounting dictionary, an auditing 
handbook, and a quarterly trilingual accounting journal. Standing 
committees of UEC are active and have established themselves as a 
strong international accounting force. Not surprisingly, UEC must 
cope with politization of internal problems — notably its relationships 
with EEC accounting policy and advisory groups. 

Not to be outdone, the profession in the Asian and Pacific countries 
held its first Far East Conference of Accountants in Manila in 1957. 
The underlying organization structure was named the Asian and 
Pacific Accounting Convention which, in the early 1970s, changed its 
name to Confederation of Asian and Pacific Accountants (CAPA). 
The ninth CAPA Conference occurred October 14-20, 1979, in Manila, 
the Philippines. 

CAPA activities are modest relative to the other international group- 
ings. The Secretariat was established in 1976 in New Zealand and 
moved to Hong Kong in 1978. An occasional newsletter is published, 
and technical committees work and report intermittently. But CAPA 
is clearly establishing itself as the professional accounting focal point 
around the Pacific rim countries. 

The latecomers among the international accounting congress/con- 
ference groups are the academics. Educators and researchers in ac- 
counting organized their first international meeting at the University 
of Illinois at Urbana-Champaign in the United States in 1962 in con- 
junction with (that is, immediately prior to) the 1962 Eighth Inter- 
national Congress of Accountants held in New York. To date, no per- 
manent secretariat or organization exists in support of the Interna- 
tional Conferences on Accounting Education. The only technical out- 
puts from these meetings are the published proceedings of the four 
venues so far. A fifth conference is planned parallel with the 1982 
Mexico City International Congress of Accountants. 

Next we turn to the more indirect effects produced by the Inter- 
national Congresses of Accountants toward greater internationalization 
of the professional scene from country to country. These effects are 
summarized very aptly in a book on the subject by the Canadian Insti- 
tute of Chartered Accountants published late in 1979. 

The most significant consequence issuing indirectly from the se- 



10 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



quence of international congresses is the establishment of the Inter- 
national Accounting Standards Committee in 1973 and the creation of 
the International Federation of Accountants in 1977. These two events 
and their subsequent further developments are discussed in other papers 
contained in the present volume. 

Of lesser but still far-reaching importance is the establishment of 
regional accounting policy groups such as the Groupe Etude as the ac- 
counting advisory arm to the Commission of the European Economic 
Community (EEC). The accounting-related directives of the EEC 
Commission are by now a well-publicized issue of multinational ac- 
counting. A similar accounting advisory group is at work on behalf 
of the ASEAN countries in the Pacific. 

In special recognition of the accounting development needs of the 
Third World, the United Nations also created and implemented an 
international accounting standards Group of Experts who function as 
an adjunct to the UN Centre on Transnational Corporations. 

The OECD Treaty Nations have likewise established their own 
Board of Experts on International Accounting Standards. One should 
be reminded that there is a fair amount of jockeying for political posi- 
tion among all of the groups currently making recommendations for 
international accounting standards. 

Finally, brief mention of a few other committees and agencies con- 
cerned with multinational accounting matters is in order. One such 
group is the Accountants International Study Group which conducted 
comparative accounting practices studies between Canada, the United 
Kingdom, and the United States and published research reports on 
various topics between 1968 and 1978. In all, this group issued twenty- 
one reports. It was dissolved when the IFAC came into being. 

Working with a similarly restricted scope is the International Com- 
mittee for Accounting Cooperation whose aim is to give professional 
accounting assistance to development efforts in Third World countries. 
This group undertook its first major study project in 1967 in Columbia, 
South America, and has worked on several smaller projects since that 
time. Representatives of this committee are regular attendees at most 
international accounting congresses and conferences. 

Academic accounting research centers have been established at the 
University of Illinois at Urbana-Champaign, at the University of 
Washington in Seattle, and at the University of Lancaster in the 
United Kingdom. These centers devote various amounts of resources 
to the study of multinational accounting problems and publish mono- 
graphs and reports. The University of Illinois also hosts an annual 



Odyssey of International Congresses of Accountants 1 1 



seminar on international accounting and publishes the semi-annual 
International Journal of Accounting Education and Research. 

RESULTS AND CONSEQUENCES TO DATE 

Tests of association are always precarious — even when based on 
statistical methodologies. Nevertheless, a few judgments seem in order 
as reference points on the observable impact of the International Con- 
gresses of Accountants. 

Wide Proliferation of the Anglo-American Financial Accounting Model 

Even though the International Congresses of Accountants have a 
truly international tradition, they clearly have become prime carriers 
of the Anglo-American conventional accounting model. During the last 
thirty years, this model has become an international standard unto 
itself. Denmark, Germany, Japan, Korea, Mexico, and Sweden, to 
name but a few examples, have all recently changed course in the 
direction of Anglo-American accounting standards and practices. The 
initial work of the International Accounting Standards Committee 
appears to have charted the same path. There seems little doubt that 
the Anglo-American type of financial accounting is much more wide- 
spread in 1979 than it was only a decade or two ago. 

Better Accounting Alignments with Actual Multinational Business Practices 

By getting a head start on its own internationalization, accounting was 
reasonably well prepared for the professional service demand onslaught 
brought about by the unprecedented growth of multinational business 
activity during the 1950s and 1960s. Accounting development is gen- 
erally thought of as lagging behind economic, legal, and social develop- 
ments. The International Congresses of Accountants have not changed 
this lagging effect, but they appear to have fostered a sense of pre- 
paredness for the era of the multinational enterprise. The degree of 
congruence between accounting service capabilities and multinational 
business demands for accounting services was certainly improved by 
the facilitating effects of international professional meetings. 

Balancing of International/ Regional, and National Interests 

Even though accounting has a long and illustrious international heri- 
tage, it turned protectively nationalistic toward the end of the 19th 
century. For all kinds of environmental (that is, nontechnical account- 
ing) reasons, professional standards and practices divided themselves 
along strictly political boundaries. In turn, this produced protectionism 



12 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



and much politicization. In the writer's judgment, the International 
Congresses did much to restore "balance" among interest groups, both 
national and transnational. 

Provision of a Number of Ancillary Benefits 

Many sophisticated observers feel that international financial capital 
markets are more efficient (both operationally and allocationally) due 
to the international "language" capabilities of accounting. Eurobond 
and Euromoney markets are regarded as prime support examples for 
this assertion. 

With international peer pressures working, the general quality of 
financial reporting and disclosures appears to have improved steadily 
in the last few years. Professor M. Edgar Barrett of Southern Metho- 
dist University has found, as have other researchers, that financial dis- 
closure quality in non-English-speaking countries has improved greatly 
in relation to financial disclosures prevailing in English-speaking coun- 
tries. A certain convergence seems to be at work here. Without the 
nurture of international understanding and communication, the finan- 
cial disclosure "gap" may still be widening instead of closing worldwide. 

There is also the matter of the research laboratory aspect. By using 
the international accounting scene as a laboratory, researchers were 
able to test current cost accounting measurement effects in the Nether- 
lands before transplanting them elsewhere. The efficiency of public 
securities markets was found to be weaker outside than inside the 
United States. The economic costs of accounting regulation were 
found to be significantly different from one country to another, even 
though the respective benefits appear to be more or less the same. There 
are a great many other instances in which international data access 
and comparative analysis have led to more reliable accounting re- 
search results. 

As we asserted at the start of this paper, the odyssey of the Interna- 
tional Congresses of Accountants seems to have followed closely the 
classical Homeric script. Of course, there is no Ithaca in accounting, 
and there is no kingdom to be secured from interlopers. But there is a 
purpose and a growing burden of responsibility. Let me close by ex- 
pressing the hope that strong continuing commitment to our interna- 
tional challenges will help us to meet new professional obligations com- 
ing our way. 



The International Federation of Accountants: 
Its Organization and Goals 

MICHAEL N. CHETKOVICH* 

INTRODUCTION AND BACKGROUND 

If I recall correctly, my last participation in this conference was in 
the spring of 1973. At that time, the accounting profession was debat- 
ing the merits of the report of the Wheat Committee, which recom- 
mended the establishment of the Financial Accounting Standards 
Board (FASB) . It was only a few days later, as I recall, that the Coun- 
cil of the American Institute of Certified Public Accountants (AICPA), 
at its spring meeting, voted to accept the report and to support the 
establishment of the FASB. 

It hardly seems possible that the FASB has been in existence for 
only six years. So much has happened in accounting since that time 
that it makes the FASB seem much older. Not the least of the develop- 
ments has been in the international field, and it is of these develop- 
ments that we speak today. 

Gerhard Mueller has told you of the history of the International 
Congresses of Accountants and of the development of certain interna- 
tional accounting organizations up to the time of the Congress in 
Sydney in October of 1972. At each of these congresses, there was rec- 
ognition of the need for better communications and closer cooperation 
among accountants on a worldwide basis and for greater harmoniza- 
tion of accounting standards. Certainly, this was a common message of 
closing speakers who exhorted their listeners to take some positive ac- 
tion toward achievement of these objectives. 

* Michael N. Chetkovich is a member of the faculty of the Department of 
Accountancy at the University of California at Berkeley. He was a partner of 
Deloitte Haskins & Sells for many years. 



14 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



EVENTS AT SYDNEY — IASC AND ICCAP 

Until Sydney, little was done. At Sydney, however, two giant steps 
which led to the formation of the International Accounting Standards 
Committee (IASC) and the International Federation of Accountants 
(IFAC) were taken. My mission here today is to talk about IFAC, 
but I must include some mention, if only a few words, of the estab- 
lishment of IASC, for, in my opinion, this was one of the more im- 
portant accounting developments of our times. 

At Sydney, representatives of the countries involved in the work of 
the Accountants International Study Group (Canada, the United 
Kingdom, and the United States) met to explore what could be done 
to develop this effort in terms of establishing some form of interna- 
tional accounting standards-setting body. Amazingly, for the pace of 
international cooperation and progress tends to be agonizingly slow, 
IASC was in existence and ready for business as a nine-country body 
by June 1973. This was truly a remarkable achievement. 

Once formed, it wasted no time proceeding with its task. Since its 
inception, it has issued approximately ten pronouncements on a va- 
riety of subjects and has a number of others in varying stages of devel- 
opment. Further, the base of participation has been broadened very 
considerably. 

IFAC took a little more doing and considerably more time. Although 
the initial step was taken at Sydney, the Federation did not come into 
being until the Congress in Munich in October of 1977. Before con- 
sidering why it took so long, let us first look at what happened in 
Sydney. 

There, the International Working Party, which was appointed at 
the Paris Congress in 1967 to plan for the Congress in Sydney in 1972 
and to present whatever other recommendations it might see fit with 
respect to other international activities, submitted its final report. In 
this report, the Working Party recommended the formation of an 
International Coordination Committee for the Accountancy Profes- 
sion (ICCAP) whose duties would include: 

1. Selection of the site for the next Congress and guidance and assis- 
tance to the host country, as appropriate; 

2. Continuing liaison with all participating bodies; 

3. Review of progress in the development of regional organizations 
and in assistance provided by bodies in more developed countries and 
the exchange of information between participating bodies; 



IFAC Organization and Goals 15 



4. Recommendation of changes for widening or amending the work 
of ICCAP — as may appear expedient; and 

5. Keeping under review the need for an international secretariat. 

WORK OF ICCAP 

The first meeting of ICCAP was held in Dusseldorf, Federal Republic 
of Germany, in April 1973. There the original membership of nine 
countries was expanded to eleven, at which number it remained until 
the end. 

Over the next four years, meetings were held generally on a twice-a- 
year basis, throughout the world. Various subcommittees which met at 
appropriate intervals and reported their findings and recommendations 
to the parent body were established. While ICCAP gave due attention 
to the entirety of its charge, its major efforts were devoted to and 
culminated in the establishment of IFAC, which came to pass some 
four and one-half years after the first meeting. 

One might well ask why it took so long, particularly in view of the 
fact that IASC was activated in a matter of a half a year or so. In 
fairness, it should be recognized that the general plan for IFAC was 
completed by the fall of 1976, at which time it was exposed for com- 
ment to all bodies (some ninety-nine) who would be eligible for 
charter membership, as an Interim Report of ICCAP. Based on com- 
ments received and further consideration of some of the issues, a final 
report setting forth the specific plan for IFAC was issued in the spring 
of 1977. Nonetheless, it did take a considerable period of time and 
it is worth a few moments to explore the reasons for this. 

DIFFICULTIES ENCOUNTERED 

To begin, it must be recognized that an international effort, by its very 
nature, is apt to take considerably longer than a similar project done 
within national boundaries. There are the inevitable problems posed by 
distance, language, and varying national biases and interests. In this 
instance, the effort involved representatives of eleven nations from 
throughout the world. While all of these representatives were both 
able and dedicated individuals, understanding and agreement could 
not and did not come overnight. 

Further, it was very much a part-time effort on the part of all con- 
cerned. There were no more than eight meetings of the Committee 
prior to Munich, generally of two days each. And while the establish- 



16 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ment of an international organization soon became the primary ob- 
jective, it was by no means, as indicated earlier, the only task. 

Added to these underlying difficulties were other factors which 
tended to prolong the effort : 

1. Initially, there was not a strong concensus as to the need for an in- 
ternational organization; 

2. There was concern for the possible negative effects such an organiza- 
tion might have on existing regional bodies; 

3. There was concern over money; the various national accounting 
bodies were having their own budgetary problems; 

4. There was a wide range of views as to the structure, duties, and 
responsibilities of such an organization; and 

5. There was concern over its impact on and relationship with IASC. 

STRENGTHS OF ICCAP 

Perhaps a more relevant question, given all of these difficulties and 
cricumstances, is how it did come to pass. A number of factors which 
contributed to the ultimate success of the mission are worthy of 
mention : 

1. The Committee was blessed with superb leadership. The chairman, 
Reinhard Goerdeler of the Federal Republic of Germany, proved to 
be an ideal choice. He was able, understanding, and fair, and soon 
came to enjoy the respect and affection of his associates. 

2. Staff support was excellent. Each Committee member was accom- 
panied and supported by one or more senior staff from his national 
body. These individuals, such as Willi Dietrich of the German Institute, 
John Hough and Philip Carrell of the English Institute, and Wallace 
Olson and Robert Sempier of the AICPA, to mention just a few and 
only as examples, were invaluable in providing both advice and assis- 
tance. Without them, the task would not have been accomplished. 

3. There was a considerable continuity of membership, and there soon 
developed an atmosphere of mutual confidence and respect. More 
than half the members served for the full life of ICCAP and several 
are continuing as members of the Council of IFAC. 

4. As time passed, there was a growing recognition of the need for 
some form of international organization and of the urgency of moving 
forward with its establishment. 



IF AC Organization and Goals 17 



ESTABLISHMENT Of IFAC 

In any event, the Committee devised a plan of organization, a constitu- 
tion, for a broadly based international organization. In October 1977, 
this constitution was signed by official representatives of fifty ac- 
countancy bodies from forty countries. Since that time, membership 
has grown to seventy-two bodies from forty-five countries, representing 
an aggregate membership of 700,000 accountants. 

As the name implies, IFAC is a federation of accountancy organiza- 
tions. Some ninety-nine such organizations were determined by ICCAP 
to be eligible to become founder members, these being bodies which 
had been eligible for official participation in the International Con- 
gress, as listed in Appendix B of the constitution. Thereafter, member- 
ship was to be by application and approval of the Council as provided 
in the constitution. 

The broad objective of IFAC, as set forth in its constitution, is the 
development and enhancement of a coordinated worldwide ac- 
countancy profession with harmonized standards. To work toward 
this objective, it is provided that IFAC shall (1) initiate, coordinate, 
and guide efforts that have as their goal the achievement of interna- 
tional technical, ethical, and educational guidelines for the accountancy 
profession and reciprocal recognition of qualifications for practice, 
working through committees and in cooperation with regional organi- 
zations; (2) encourage and promote the development of regional 
organizations; and (3) arrange for the holding of international 
congresses. 

STRUCTURE OF IFAC 

IFAC is an association formed under the Swiss Civil Code and, ac- 
cordingly, its registered office is designated as Geneva. However, its 
administrative office is in New York City. The senior governing body 
of IFAC is its Assembly which is composed of one representative from 
each of the member organizations. According to the constitution, the 
principal powers and duties of the Assembly include (1) election of 
the members of the Council; (2) decisions, upon the recommendation 
of the Council, as to the timing, location, and host body(ies) of each 
International Congress of Accountants; (3) the financial contributions 
to be paid by member bodies; (4) determination of member bodies 
to be expelled in accordance with provisions of the constitution; and 
(5) amendments to the constitution. 



18 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



It is provided that the Assembly shall hold a regular ("ordinary") 
meeting during or immediately prior to each International Congress 
and that special meetings may be called in accordance with specified 
procedures. 

It is obvious that, because of its size and the infrequency of its meet- 
ings, the Assembly is not the agency to manage the affairs of the Fed- 
eration. Rather, this is the function of the Council which consists of 
fifteen representatives of member bodies from fifteen countries who are 
elected at ordinary meetings of the Assembly and serve until the next 
ordinary meeting, which normally would be a period of five years. 

The constitution delegates to the Council a wide range of duties and 
responsibilities and in addition provides that it shall "take any action 
which is in the general interests of IFAC and which is not expressly 
denied to it by this constitution. . . ." 

Meetings of the Council are to be held at such times and places as 
it may decide, providing that there be at least one meeting a year. In 
practice, the Council has been following a schedule of two meetings a 
year. 

The constitution provides that the Council shall elect from among 
its members a president, a deputy president, and two vice presidents. 
The terms of the president and deputy president are fixed at two and 
one-half years, and each is limited to one term. The vice presidents 
serve for a term determined by the Council, which may not exceed five 
years. 

FINANCES 

The initial dues structure is set forth in an appendix to the constitution 
and is expected to remain unchanged at least until the meeting of the 
Assembly in connection with the International Congress in Mexico 
City in 1982. Dues are scaled according to the size of the member 
body's membership and range from a minimum of $200 to a maximum 
of $23,000. There is provision for reduced dues for member bodies 
from countries where the per capita income is less than $2,000 per 
annum. 

The dues schedule was set so as to provide an estimated average an- 
nual revenue of $180,000 for the first five years of the Federation's 
existence. As a supplement to this dues revenue, the AICPA volun- 
teered to absorb the Federation's occupancy and certain related costs. 
Thus, il can be seen that this fledgling organization operates on a very 



IFAC Organization and Goals 19 



modest budget. It has only three full-time employees: an executive 
director, an assistant, and a secretary. 

RELATIONSHIP WITH IASC 

When IASC and ICCAP were formed, it was provided that IASC 
would be "a part of" ICCAP but that it would be autonomous in its 
function of setting international accounting standards. Thus IASC had 
its own financing and staff, and ICCAP did not involve itself in the 
operations of IASC. However, there was a close liaison between the 
two organizations. 

The constitution of IFAC recognizes IASC as the international ac- 
counting standards-setting body and provides that this past relationship 
shall be carried forward "on the same general basis" and that "it is 
recognized that the objectives of IASC and IFAC are interdependent 
and agreed that the closest relationship should be maintained between 
the two bodies." 

While there is no reason to question that IASC will continue to be 
recognized and to function as the accounting standards-setting body, 
it is not unreasonable to expect that, at some future time, the two 
organizations will be brought closer together structurally. Certainly, 
the relationship between the two will be, and needs to be, a very close 
one. 

RELATIONSHIP WITH REGIONAL ORGANIZATIONS 

It is contemplated, and IFAC's constitution provides, that it will 
work closely with established regional accounting organizations of 
which there now are three, so that there will be no unnecessary dupli- 
cation of cost and effort. To encourage and to promote such coopera- 
tion, it is provided that a representative of each of these organizations 
shall be entitled to attend all meetings of the Council and to have the 
privilege of the floor at such meetings. 

IFAC WORK PROGRAM 

At the initial meetings of the Assembly and of the Council in Munich, 
a twelve-point work program was accepted and seven committees were 
established. Robert Sempier will discuss what IFAC has been doing 
since its establishment at Munich and the work of these committees, 
so these topics will not be pursued here. Suffice it to say that there has 
been considerable activity, and the progress is encouraging. 



20 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



SUMMARY AND CONCLUSION 

It must be obvious that IFAC labors under some significant weaknesses 
and limitations. It begins life with all of the problems of a new interna- 
tional body, relying largely on volunteer effort and with little or no 
authority over anyone or anything. As has been noted, it has very 
limited resources in both funds and staff. 

Yet IFAC also has some significant strengths. There is a strong 
sense of commitment on the part of the organizations and individuals 
who were instrumental in its establishment to make it work. It has 
exceptional leadership in the persons of its president, Reinhard Goer- 
deler, mentioned earlier, and its vice president, Gordon Cowperthwaite 
of Canada. And it has as its first executive director an individual who 
is well-known and highly respected among accountants throughout the 
world, Bob Sempier. It would be very difficult to conceive of anyone 
better fitted for this difficult assignment than Bob. 

Thus, while IFAC is new and its future is subject to many uncer- 
tainties, it nonetheless must be recognized as a very significant develop- 
ment on the international scene and one that has considerable potential 
for contributing to the advancement of accounting internationally. 
Certainly it deserves our strongest support. With such support, I am 
confident that it will prove to be a strong and positive force in achiev- 
ing greater international cooperation and harmonization in accounting. 



The International Federation of Accountants: 
Operating Procedures and Current Progress 

ROBERT N. SEMPIER* 



The International Federation of Accountants (IFAC) is a new and 
exciting organization of great significance to the accounting profes- 
sion worldwide. Those of us who were associated with the Interna- 
tional Coordination Committee for the Accountancy Profession 
(ICCAP) and now with IFAC know that progress can be made on a 
planned basis in an international organization of this type. However, 
expectations must not be unduly high, since any organization repre- 
senting seventy-two accountancy bodies from fifty-five countries must 
take time to settle and adjust in a variety of ways. 

As a result, we have attempted to design a work program for IFAC 
that is both reasonable in terms of expected accomplishments and at 
the same time sufficiently aggressive to demonstate to our membership 
and other interested organizations that IFAC is moving steadily for- 
ward in fulfilling its objective — the development and enhancement of 
a coordinated world-wide accountancy profession with harmonized 
standards. In determining the work program for the first five years, 
we have also kept in mind that IFAC has a modest staff consisting of 
two and one-half professionals with secretarial support. As such, we 
must give considerable attention to our priorities and concentrate our 
efforts on those areas which are most likely to produce the best results. 

* Robert N. Sempier is the executive director of the International Federation 
of Accountants. 



22 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



BASIC OBJECTIVES OF IFAC 

The basic objectives of IFAC are, in general terms, 

1. To work towards international technical, ethical, and educational 
guidelines — and towards reciprocal recognition of practice qualifica- 
tions — through committees and subcommittees of IFAC ; 

2. To promote and assist in the development of new regional organi- 
zations; and 

3. To arrange International Congresses of Accountants which will al- 
low members of the profession worldwide to exchange ideas, to keep 
informed, and to reach broad conclusions on desired common aims. 

BASIC OBJECTIVES OF IFAC's PROGRAM OF WORK 

IFAC has developed a twelve-point work program to serve as a guide 
to IFAC committees and staff over the first five years. 
The basic elements of this program are to : 

1. Develop statements which can serve as guidelines for international 
and auditing guidelines; 

2. Establish the basic principles which should be included in the code 
of ethics of any member body of IFAC and to refine or elaborate on 
such principles as deemed appropriate; 

3. Determine the requirements and develop programs for the profes- 
sional education and training of accountants; 

4. Collect, analyze, research, and disseminate information on the man- 
agement of public accounting practices to assist practitioners in more 
effectively conducting their practices; 

5. Evaluate, develop, and report on financial management and other 
management techniques and procedures ; 

6. Undertake other studies of value to accountants, such as a possible 
study on the legal liability of auditors; 

7. Foster closer relationships with users of financial statements includ- 
ing preparers, trade unions, financial institutions, industry, govern- 
ment, and others; 

8. Maintain good relations with regional organizations and explore 
the potential for establishing other regional organizations, as well as 
assisting in their organization and development; 

9. Establish regular communications among the members of IFAC and 
other interested organizations, principally through an IFAC Newsletter; 

10. Organize and promote the exchange of technical information, ed- 
ucational materials and professional publications, and other literature 
emanating from member bodies. 



IF AC Operating Procedures and Current Progress 23 



11. Organize and conduct an international congress of accountants 
approximately every five years ; and 

12. Seek to expand the membership of IFAC. 

IFAC has established the following committees in an attempt to deal 
with the foregoing work program. 

1. Auditing; 

2. Education; 

3. Ethics; 

4. International Congress; 

5. Management Accounting; 

6. Planning; and 

7. Regional Organizations. 

I can only tell you that it was no easy task to organize these commit- 
tees. The problem, of course, was that the members are spread all over 
the world. 

THE INTERNATIONAL AUDITING PRACTICES COMMITTEE (IAPC) 

The aims of this committee are to develop and issue, on behalf of the 
Council of IFAC, guidelines on generally accepted auditing practices 
and the form and content of audit reports. It also seeks to promote, 
with the support of the Council, the voluntary acceptance of such 
guidelines. 

IAPC comprises one nominated member from each of the follow- 
ing countries: Australia, France, India, Mexico, Philippines, the United 
States of America, Canada, the Federal Republic of Germany, Japan, 
the Netherlands, and the United Kingdom and Republic of Ireland. 

The committee's inaugural meeting was held in New York in March 
1978. While the major part of this meeting was occupied with the 
establishment of administrative and operating procedures, discussion 
on the work program indicated that there was a wealth of auditing 
experience represented on the committee. 

It is my belief that auditing is potentially an international language 
to a greater extent than are taxation and accounting which tend to be 
influenced to a greater extent by national legislation. This view was 
supported by the review which the committee undertook of the stan- 
dards already in force in member countries, for it was apparent that 
most of the differences were historical in nature with little technical 
justification. 

While it was easy to reach agreement that the committee in its 
work should aim to use existing literature wherever possible and not 



24 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



seek to "reinvent the wheel," this policy provides difficulties in prac- 
tice as it remains to be determined which of the differing statements 
is to be chosen as the basis for drafting the international model. 

INTERNATIONAL AUDITING GUIDELINES 

Within each country, local conditions govern to a greater or lesser de- 
gree the auditing of financial information. Such regulations may be of 
a statutory nature or take the form of auditing standards or statements 
issued by professional or regulatory bodies, or possibly a combination 
of both. 

AUTHORITY 

It is important to recognize that the International Auditing Guidelines 
issued by IAPC do not and cannot override regulations governing the 
audit of financial information in any member country. To the extent 
that International Auditing Guidelines conform with local regulations 
on a particular subject, the audit of financial information in that 
country in accordance with local regulations will automatically comply 
with the International Auditing Guideline in respect to that subject. 
In the event of local regulations differing from, or being in conflict 
with, International Auditing Guidelines on a particular subject, mem- 
ber bodies, in accordance with the constitution of IFAC, should work 
towards the implementation of the Guideline issued by IAPC, when 
and to the extent practicable. 

SCOPE 

International Auditing Guidelines apply whenever an independent 
audit is carried out, that is, in the independent examination of financial 
information of any entity, whether profit oriented or not, and irrespec- 
tive of its size, or legal form, when such an examination is conducted 
with a view to expressing an opinion thereon. International Auditing 
Guidelines may also have application as appropriate to other related 
activities of auditors. Any limitation of the applicability of a specific 
International Auditing Guideline is made clear in the introductory 
paragraph to that Guideline. 

WORKING PROCEDURES 

The agreed working procedure of IAPC is to select subjects for de- 
tailed study by a subcommittee established for that purpose. IAPC 
delegates to the subcommittee the initial responsibility for the prepara- 



IF AC Operating Procedures and Current Progress 25 



tion and drafting of auditing guidelines. The subcommittee studies 
background information in the form of statements, recommendations, 
studies or standards issued by member bodies, regional organizations, 
or other bodies, and as a result of that study, an exposure draft is pre- 
pared for consideration by IAPC. If approved by at least three- 
quarters of the total voting rights of IAPC, the exposure draft is widely 
distributed for comment by member bodies of IFAC, and to interna- 
tional agencies as IAPC may determine. Adequate time is allowed 
for each exposure draft to be considered by the persons and organiza- 
tions to whom it is sent for comment. 

The comments and suggestions received as a result of this exposure 
will then be considered by IAPC and the exposure draft revised as 
appropriate. Provided that the revised draft is approved by at least 
three-quarters of the total voting rights of IAPC, it will be issued as a 
definitive International Auditing Guideline becoming operative from 
the date specified in the guideline. 

IAPC WORK PROGRAM 

The initial work program was determined at the first meeting, and the 
committee has agreed that at least one new topic would be added at 
each meeting. Timing difficulties arise in setting a work schedule time- 
table because the multiplicity of languages in use by member bodies 
creates a translation problem. Allowing four months for translation 
and a similar period for exposure results in a period of twenty-one 
months from the commencement of the study to the final issue of a 
guideline. 

The current work program of the committee is as follows: 

Topic 1 — Objective and Scope of the Audit of Financial Statements 
Subcommittee — Canada (chairman), Argentina, Mexico, and Swit- 
zerland. 

Status — Approved by IAPC for issue as an exposure draft November 
1978. Release date — February 1, 1979. 

Topic 2 — Engagement Letters 

Subcommittee — Germany (chairman) , India, and Sweden. 

Status — Approved as an exposure draft at the IAPC meeting held 

mid-March 1979. The exposure draft will be released on May 1. 

Topic 3 — Basic Principles Governing an Audit 

Subcommittee — Australia (chairman), Canada, and the Netherlands. 

Status — Subcommittee currently reviewing fifth working draft. An- 



26 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ticipate approval as an exposure draft at the June 1979 IAPC meeting. 
This project covers general, performance, and reporting standards. 
It is regarded as the foundation project for the future work of IAPC, 
as practice guidelines will be issued elaborating on each of the basic 
principles in greater detail. 

Topic 4 — Standard Inter-Bank Confirmation Letter — Special Project 
Subcommittee — United Kingdom and Ireland (chairman), the Neth- 
erlands, Germany, and the United States (in liaison with the Group of 
Ten Bank Supervisors) . 

Status — First draft reviewed at IAPC March 1979 meeting. 
This project was requested by the Group of Ten Central Bank gov- 
ernors. Approval for exposure is hoped for at the June IAPC meeting. 
Whether this document will be issued as an Auditing Guideline will be 
determined at a later date. 

Topic 5 — Reliance on Other Auditors 

Subcommittee — France (Chairman), United Kingdom and Ireland, 

and the United States. 

Status — Chairman presented a points outline at the IAPC meeting 

in March 1979. 

Topic 6 — Planning 

Subcommittee — Netherlands (chairman) , Hong Kong, and the Philip- 
pines. 

Status — Chairman presented a points outline at the March 1979 
IAPC meeting. 

This is the first of the practice guidelines to be developed to amplify 
the basic principles. 

At the committee's recent meeting, it was agreed that the next 
three topics to be undertaken by the commitee would be internal con- 
trol, supervision and delegation, and evidence. We are presently in 
the process of organizing subcommittees for the first two of these topics. 

RELATIONSHIP WITH IASC 

IAPC hopes that it will be able to match the progress made by IASC 
since its formation in 1973. IFAC has established a close working re- 
lationship with IASC and both bodies are liaising on a regular basis. 
However, once IAPC has issued the International Auditing Guide- 
line — Basic Principles Governing An Audit and the practice guidelines 
elaborating on each basic principle, a substantial part of our future 
work will be interdependent with that of IASC. Both committees will, 



IF AC Operating Procedures and Current Progress 27 



however, work in close cooperation and collaboration to ensure that 
there is harmony in our approach and output. 

IAPC — THE FUTURE 

The first exposure draft published in February is in itself simplistic and 
must be considered in the context of the work program detailed above. 
It is likely that a period of from three to five years will elapse before 
the IAPC guidelines match auditing standards already on issue in 
most developed countries. This period should therefore be regarded 
as one of establishment and consolidation of its acceptance as the 
international authority on auditing matters. This acceptance can be 
achieved only by professional performance by IAPC, with the support 
of its member bodies and, in turn, by individual members of those 
bodies. 

EDUCATION COMMITTEE 

The terms of reference of this committee are to prepare a survey 
setting forth, for each member organization, a summary of the entry 
requirements, examination or alternative educational requirements, 
and practical experience requirements, and to develop guidelines on 
prequalification, training, and education. It will also review develop- 
ments with respect to required continuing professional education and 
in due course will develop guidelines for members who are contem- 
plating a move toward required CPE. 

At its first meeting, the committee agreed to undertake the follow- 
ing programs of work : 

1 . Preparation of guidelines on 

(A) Prequalification education and training for an accountant 

(B) The theoretical content of studies and examinations indicating 
in general terms the educational content to which students of 
accountancy should be exposed 

2. Preparation of a statement emphasizing the need for member bodies 
to develop programs of postqualifying education and to encourage 
member bodies which have developed such programs to make them 
available at reasonable prices to other bodies which do not have 
the resources to develop their own material. 

ETHICS COMMITTEE 

It is well established that ethics and independence are of vital concern 
to the accounting profession worldwide. This committee has as its terms 



28 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



of reference to develop a suggested minimum code of professional 
ethics and to promote understanding and voluntary acceptance of such 
code. 

A paper entitled "Professional Ethics for the Accountancy Profes- 
sion" prepared by the committee was submitted to the November meet- 
ing of the Council for review and has been resubmitted to the May 
meeting of the Council with a request that the committee be author- 
ized to send the paper to the member bodies of IFAC for their review 
and comment. The paper itself sets forth the statement of principles 
which should form the basis of a detailed code of ethics by which 
members of the profession should be guided in the conduct of their 
professional lives. In addition, the committee is in the process of de- 
veloping detailed papers on each of the matters covered in the basic 
principles setting forth the advantages and disadvantages of each 
principle for use by the member bodies in preparing or modifying their 
own code of professional ethics. The committee has also begun work 
on a model code of ethics to which all members of IFAC might 
subscribe. 

INTERNATIONAL CONGRESS COMMITTEE 

The International Congress Committee has oversight of the plans and 
arrangements for the 1982 Congress. In broad and most tentative terms, 
I can report that the technical program will probably allow each par- 
ticipant to elect to participate in three discussion groups from among 
six technical subjects. At present, it is contemplated that the following 
technical subjects will be considered: (1) Image of the Profession; 
(2) Education of the Accountant; (3) Accounting Principles; (4) Au- 
diting; (5) Management Accounting ; and (6) Contribution of the Pro- 
fession to Government. 

Now that we have a formally constituted international organization, 
IFAC's committees are expected to take a leading role in the prepara- 
tion of the background papers to be used as a basis for discussion by 
participants in the discussion groups. 

MANAGEMENT ACCOUNTING COMMITTEE 

It is well recognized that in many countries, management accountants 
— those not in public practice — equal approximately half of the 
total members of accounting bodies. IFAC recognizes that those who 
practice management accounting in industry, government, and else- 



IFAC Operating Procedures and Current Progress 29 



where are vitally affected by auditing and accounting standards. It is 
for these reasons that we have given significant recognition to this 
particular area of our membership. As such, preparers and users of 
financial statements are asked to contribute to the work of the Man- 
agement Accounting Committee and to assist in advancing standards 
of management accounting in both developed and developing countries. 

The Council of IFAC has placed the onus on this committee to en- 
courage the development of management accounting and to undertake 
studies of direct concern to management accountants, as well as to 
stimulate an increased level of competence and thereby improve the 
standing and recognition of management accountants. 

I look forward to this committee to develop papers on the following 
areas: 

1. Boundaries of management accounting, the responsibilities of the 
management accountant, and the relationship of the management ac- 
countant and the auditor; 

2. Framework to use when compiling a bibliography on management 
accounting; and 

3. Concepts of information systems for nonprofit organizations. 

It is also planned to obtain information on the participation by mem- 
bers not in public practice in the activities of the member bodies of 
IFAC. 

REGIONAL ORGANIZATION COMMITTEE 

As previously indicated, an important objective of IFAC through its 
Regional Organizations Committee is to encourage and promote com- 
mon objectives and to develop guidelines for the structure and consti- 
tution of new regional organizations. In addition, the committee is in 
the process of developing a paper outlining the criteria to be used by 
IFAC for recognition of new regional organizations. 
IFAC recognizes three regional organizations: 

1. Confederation of Asian and Pacific Accountants (comprises twenty- 
eight member accounting organizations in twenty-one countries in Asia 
and the Pacific) ; 

2. Interamerican Accounting Association (comprises twenty-eight 
member accounting organizations in twenty-two countries in the 
Americas) ; and 

3. Union Europeenne des Experts Comptables Economiques et Finan- 



30 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ciers (comprises twenty-seven member accounting organizations in 
twenty-one countries in Europe) . 

The committee's terms of reference also require it to see that the 
recognized regional organizations are invited to: (1) provide advice 
on and participate in the program of work of IFAC; (2) comment on 
draft guidelines; (3) make available to each other and to IFAC for 
their information and use, all studies or statements which they issue; 
(4) adopt, as appropriate, and publish to their own members, IFAC's 
guidelines, statements and studies; and (5) develop recommendations 
on communications between IFAC and regional organizations con- 
cerning their respective programs of work. 

COUNCIL AND PLANNING 

The Council is responsible for implementing the objectives of IFAC 
and overviews the work of the committees to satisfy itself that IFAC 
is moving steadily forward in fulfilling its objective — the development 
and enhancement of a coordinated, worldwide accountancy profession. 
A planning committee composed of members of the Council main- 
tains relevance of IFAC's continuing objectives and contributes to their 
advancement by reviewing strategy plans and constitutional matters 
prior to discussion by the Council. 

RELATIONSHIP WITH OTHER ORGANIZATIONS 

The membership of IFAC now stands at seventy-two accountancy 
bodies in fifty-five countries representing over 700,000 accountants in 
public and private practice, education, and government service. As an 
organization, we have the capability and responsibility of assuming a 
greater role on the world scene on initiatives developed by other world 
organizations that have an impact on the profession. In this regard, 
considerable emphasis will be given to increasing the visibility and in- 
volvement of IFAC in such activities. As a start, I believe IFAC and 
the United Nations Centre on Transnational Corporations have de- 
veloped mutually satisfactory working arrangements for keeping each 
other informed and, as appropriate, to provide guidance and assistance 
on matters of common interest. 

In addition, it will be important that the closest cooperation and 
coordination be established between the International Accounting 
Standards Committee and IFAC so that the full impact of our re- 
sources and expertise can be brought to bear in a rational and re- 



IF AC Operating Procedures and Current Progress 31 



sponsible manner. In accordance with an agreement between both 
parties that the closest relationship should be maintained between 
IFAC and IASC, arrangements have been made between the officers 
of each organization to meet regularly, exchange information, and re- 
view the ways in which they can work together and perhaps in due 
course to formally integrate IASC into IFAC. 

CONCLUSION 

Our program will be considered by many to be ambitious but with 
goodwill and effort, IFAC can strengthen and enhance the significance 
of the role played by the accounting profession worldwide. 



SFAS No. 8: Conforming, Coping, 
Complaining, and Correcting! 



THOMAS G. EVANS and WILLIAM R. FOLKS, JR.* 



INTRODUCTION 

The primary purpose of this paper is to examine Statement of Finan- 
cial Accounting Standards (SFAS) No. 8 and the response it evoked 
in multinational corporations (MNCs). This response is divided into 
four phases: how MNCs conformed to SFAS No. 8 in late 1975 or 
1976; how they have coped with it since that time until the present; 
how they have complained about it during the same time period; and 
how they have tried to have it corrected, essentially a 1978-79 phenom- 
enon. This paper is based on the authors' research study published by 
the FASB 1 and relies upon the questionnaire response of 156 U.S.- 
based MNCs. Exhibit 1 presents some data on the respondents. 

CONFORMING: THE INITIAL IMPACT OF SFAS NO. 8 

One of the reasons for the controversy over No. 8 is that it accom- 
plished one of its main purposes. It put an end to the diversity in trans- 
lation practices that existed prior to its issuance. Thus, many MNCs 

* Thomas G. Evans is associate professor of accounting at the College of Busi- 
ness Administration, University of South Carolina. 

William R. Folks, Jr., is professor and program director of international business 
at the College of Business Administration, University of South Carolina. 
1 Thomas G. Evans, William R. Folks, Jr., and Michael Jilling, The Impact of 
Statement of Financial Accounting Standards No. 8 on the Foreign Exchange 
Risk Management Practices of American Multinationals: An Economic Impact 
Study (Stamford, Conn.: Financial Accounting Standards Board, 1978). 



34 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 1. Corporate Characteristics of Respondents 



Overall size of participating 


Approximate relative size of 


companies* 




foreign c 


)perations'\ 




Consolidated an- 






Ratio of foreign 






nual sales in U.S. 


156 


firms 


sales to total sales 


156 firms 


dollars, fiscal 


from 


1977 


on annual basis, 


from 


1977 


year, 1976 data 


Number 


Percent 


1976 data 


Number 


Percent 


One billion and 






Below 20 percent 


33 


21.2 


above 
Between 300-1,000 
million 


92 
50 


59.0 
32.0 


Between 20-40 
percent 


86 


55.1 


Below 300 million 


14 


9.0 


Above 40 percent 


35 


22.4 


No response 





0.0 


No response 


2 


1.3 


Total 


156 


100.0 


Total 


156 


100.0 



* 82.1 percent of the companies participating in this study were on the 1977 Fortune 500 list 
of largest industrial corporations. 

t.31.4 percent of the companies participating in this study are "old" Multinational Corpora- 
tions (MNCs) (achieved MNC status prior to I960); 66.0 percent are "new" MNCs (achieved 
MNC status since 1960); another 2.6 percent did not respond to this question. 



found that their translation practices had to be changed to conform 
to No. 8. 

The introductory paragraph of SFAS No. 8 (paragraph 1) indi- 
cates that one of the three factors that highlighted the problems asso- 
ciated with currency translation was ". . . the acceptance in practice of 
significantly different methods of accounting." 2 Evidence to support 
this concern is found from the authors' survey. From the data in exhibit 
2, it is clear that there were at least six different translation methods 
in use prior to the issuance of SFAS No. 8. The most popular alterna- 
tives were the current-noncurrent method, the monetary-nonmonetary 
method, and two variations of those methods. An analysis of the re- 
sponse to the survey, however, shows that only 29 of the 141 firms re- 
sponding to this question (approximately 20 percent) were already in 
conformity with SFAS No. 8 when it was issued. Thus, 80 percent of 
the firms had some adjustments to make. 

One area when an adjustment was likely to be needed was in the 
translation practices for inventories. According to a previous survey by 
the authors conducted in 1975 prior to the issuance of SFAS No. 8 

2 Financial Accounting Standards Board, Accounting for the Translation of 
Foreign Currency Transactions and Foreign Currency Financial Statements, 
Statement of Financial Accounting Standards No. 8 (Stamford, Conn.: FASB, 
1975). 



10 


6.4 


22 


14.1 


41 


26.3 


7 


4.5 


4 


2.6 


3 


1.9 


15 


9.6 



SFAS No. 8: Conforming, Coping, Complaining, and Correcting 35 



Exhibit 2. Translation Methods Used by U.S. Multinationals 
Prior to the Issuance of SFAS No. 8 

Respondent firms 
Translation methods Number Percent 

Current-noncurrent method 54 34.6 

Current-noncurrent method with noncurrent receivables 

and payables translated at the current rate 
Monetary -non monetary method 
Monetary-nonmonetary method with inventories 

translated at the current rate 
Temporal method 
Current rate method 
Other 
No response 

Total 156 100.0 



and based on the response of 107 firms, 3 63 to 68 percent of the firms 
translated inventory at the current rate. However, SFAS No. 8 requires 
that inventory be translated at a historical rate in general. It was 
found that between 67 to 70 percent of the firms were now translating 
inventory at the historical rate in conformance with SFAS No. 8. 

Exhibit 3 presents the firms' methods of treating translation gains 
and losses. This exhibit shows that the majority of respondents were 
already in conformity with the FASB in that they recognized such gains 
and losses in current income. However, approximately 37 percent were 
deferring gains and losses according to some criteria and faced some 
adjustment to come into conformity with No. 8. 

Because it was suspected that firms faced some adjustment to SFAS 
No. 8, 4 some direct questions on this issue were posed. To obtain a 
measure of the cost of conforming to SFAS No. 8, firms were asked first 
to assess qualitatively their initial implementation effort to SFAS No. 
8 and then to quantify their estimate of the cost of that effort. Results 
are presented in exhibits 4 and 5. The largest number of firms reported 
that they needed only a "minor effort" to conform to SFAS No. 8; 
only eleven firms said it took "no effort" ; and twenty-three firms indi- 
cated it took a "major effort." In terms of their estimate of the total 

Michael Jilling, Foreign Exchange Risk Management in U.S. Multinational 
Corporations (Ann Arbor, Mich.: UMI Research Press, 1979). 

Thomas G. Evans, "Diversity in Foreign Currency Translation Methods — A 
Proposal for Uniformity," CPA Journal (February 1974). 



58 


37.2 


1 


0.6 


2 


1.3 





0.0 


7 


4.5 


8 


5.1 



36 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 3. Translation Gain and Loss Treatments Used by U.S. Multinationals 
Prior to the Issuance of SFAS No. 8 

Respondent firms 
Gain and loss treatment Number Percent 

Recognize in income currently 80 51.3 

Defer based on certain criteria 

Adjust stockholders' equity 

Amortize over life of long-term debt 

Adjust cost of nonmonetary assets or amortize over 

life of such assets 
Other 
No response 

Total 156 100.0 



Exhibit 4. Degree of Effort Required by U.S. Multinational Corporations 
to Conform Their Translation Methods to SFAS No. 8 

Respondent firms 
Degree of effort Number Percent 

No effort necessary 11 7.1 

Minor effort 62 39.8 

Moderate effort 59 37.8 

Major effort 23 14.7 

No response 1 0.6 

Total 156 100.0 



Exhibit 5. Cost of the Initial Implementation Effort at U.S. 
Multinational Corporations Due to SFAS No. 8 

Respondent firms 
Cost 

Under $5,000 

$5,000-10,000 

$10,000-20,000 

$20,000-50,000 

$50,000-100,000 

Over $100,000 

No response 

Total 156 100.0 



Number 


Percent 


27 


17.3 


26 


16.7 


14 


9.0 


29 


18.6 


15 


9.6 


20 


12.8 


25 


16.0 



SFAS No. 8: Conforming, Coping, Complaining, and Correcting 37 



clerical, managerial, and auditing cost of that initial implementation 
effort, the largest number of firms claimed it cost between $20,000 and 
$50,000 each. Twenty firms reported that their cost was over $100,000. 
The average cost was $35,000 per firm, in the authors' opinion not a 
significant figure. 

COPING WITH NO. 8 

Since firms found themselves living with No. 8 (especially since the 
FASB voted not to reconsider it in April 1976), they have turned to a 
number of tools to help cope with the requirements of the standard. 
These tools are labeled "exposure adjustment techniques" in the au- 
thors' report, and at least twenty-one separate tools were recognized. A 
substantial part of the research report concentrates on these tools and 
the degree of utilization associated with them by MNGs since the 
issuance of SFAS No. 8. The following summary presents the high- 
lights for the findings with regard to this important subject: 

Financial exchange risk management techniques are the most widely used. 
The most popular technique, in an overall sense, is to increase the foreign- 
currency borrowing levels in weaker currencies. Second is the acceleration or 
deceleration of subsidiary dividend payments. From a usefulness viewpoint, 
firms ranked increasing borrowing levels as first and forward exchange con- 
tracts as second. 

Firms have made noteworthy changes in overseas borrowing patterns since 
January 1, 1976. They have reduced borrowings in the German mark and 
Swiss franc and increased borrowings in the British pound, Canadian dollar, 
French franc, and the Mexican peso. Borrowings stayed at the same level in 
the Japanese yen. 

Firms have been using forward contracts to cover their accounting ex- 
posure more extensively since January 1, 1976. This is particularly true in 
the following currencies: Canadian dollar, French franc, German mark, 
Japanese yen, and Mexican peso. The firms also reported to us that the 
volume of their forward contracts has expanded substantially. 

A majority of the respondents believed that it is possible to hedge ac- 
counting exposure selectively with a reasonable prospect of success. The belief 
that there is a payoff to the firm from the selective use of forward con- 
tracts is even more widely held.** 5 

It was also found that the pre-SFAS No. 8 translation and exchange 
gain or loss treatment practices have had a significant impact on how 
firms have coped with No. 8. Particularly with regard to the use of 
forward contracts, those firms that were required to change their ac- 
counting practices to conform to SFAS No. 8 have increased their use 

8 Details on the views of respondents on any issue marked "**" are presented 
in exhibit 6. 



38 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



of forward contracts more than other firms. These results led to the 
conclusion that the firms that did not conform to SFAS No. 8 when it 
was issued are pursuing more aggressive FERM 6 programs. 

Exhibit 6. Opinions and Views of the Respondents on Selected Issues 

There is a payoff to the firm from the selective use of forward-exchange 
contracts. 

Extent of agreement and the percent of respondent firms 

Strongly Strongly No 

agree Agree Not sure Disagree disagree response 

14.7 50.2 19.2 11.5 3.8 0.6 



Currently prevailing accounting principles mislead management, stockholders, 
and security analysts, because the cost of protection against exchange-rate 
changes is not separately identified, while exchange gains and losses can be 
highly visible in the consolidated income statements of multinational corpo- 
rations. 



Extent of agreement and the 


percent of 


respondent firms 




Strongly 
agree 


Agree 


Not sure 


Disagree 


Strongly 
disagree 


No 
response 


47.4 


35.9 


10.3 


3.8 


1.3 


1.3 



Our company needs a more flexible method of translating foreign-currency 
balance sheet items than SFAS No. 8. 



Extent of agre* 


ement and the 


percent of 


respondent firms 




Strongly 
agree 


Agree 


Not sure 


Disagree 


Strongly 
disagree 


No 
response 


38.5 


21.8 


26.9 


7.7 


4.5 


0.6 



* Foreign Exchange Risk Management — FERM. 



SFAS No. 8: Conforming, Coping, Complaining, and Correcting 39 



Exhibit 6 (cont. 


) 








Current accounting principles allow a 
of an exchange-rate adjustment. 


satisfactory 


measure of the total effect 


Extent of agreement and the 


percent of ; 


respondent firms 




Strongly 
agree 


Agree Not sure 


Disagree 


Strongly 
disagree 


No 
response 


1.9 


14.1 15.4 


25.0 


43.0 


0.6 


The translation principles of SFAS No. 8 result ir 
firm's actual exposure to foreign-exchange risk. 


l an accurate measure of a 


Extent of agreement and the 


percent of respondent firms 




Strongly 
agree 


Agree Not sure 


Disagree 


Strongly 
disagree 


No 
response 


1.3 


9.6 12.8 


31.4 


44.3 


0.6 



SFAS No. 8 is causing American financial management to overemphasize 
the income impact of foreign-exchange gains and losses as compared to finan- 
cial considerations (cash flows) in decision making. 



Extent of agreement and the percent of respondent firms 


Strongly 
agree 


Strongly 
Agree Not sure Disagree disagree 


No 
response 


32.1 


43.6 13.5 8.3 0.6 


1.9 


Investment in 


inventory is not subject to exchange risk. 




Extent of agreement and the percent of respondent firms 


Strongly 
agree 


Strongly 
Agree Not sure Disagree disagree 


No 
response 


2.6 


7.1 3.2 26.3 59.5 


1.3 



A foreign-exchange reserve, set up specifically to cushion the effect of for- 
eign-exchange gains and losses on the consolidated income statement, is the 
best approach to deal with foreign-exchange risk. 



40 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 6 (com.) 





Extent of agreement and the 


percent of 


respondent firms 




Strongly 
agree 


Agree 


Not sure 


Disagree 


Strongly 
disagree 


No 
response 


23.7 


23.1 


21.8 


17.3 


13.5 


0.6 


Exchange-rate adjustments should be deferred when the exchange-rate change 
that brought about the adjustment is considered temporary. 


Extent of agreement and the 


percent of 


respondent firms 




Strongly 
agree 


Agree 


Not sure 


Disagree 


Strongly 
disagree 


No 
response 


14.7 


29.5 


18.6 


19.2 


16.7 


1.3 



COMPLAINING ABOUT NO. 8 

The controversial nature of SFAS No. 8 is almost legendary in modern 
standard setting. Certainly it has created a storm of protest that con- 
tinues today. The complaints associated with No. 8 fall into two basic 
categories : ( 1 ) that the requirement in No. 8 that all translation gains 
and losses be recognized in current income causes the reported earnings 
fluctuations of MNCs to increase and thus adversely affect the market 
price of their common stock, and (2) that the management of MNCs 
attempt to avoid any anticipated increase in the volatility of reported 
earnings by an increase in the use or change in the nature of FERM 
practices. This second concern is often referred to as "chasing un- 
realized items with cash." Additionally, a third area of complaint has 
been raised at times; this is that the MNCs' hedging activities in the 
world's currency markets, because of SFAS No. 8, puts downward pres- 
sure on the American dollar. This issue was addressed at a meeting 
held by the United States Treasury in July 1978. 

The firms in our survey were sharply critical of SFAS No. 8 in the 
following areas : 

A little more than 82 percent of the respondents agreed that Statement 
No. 8 has been an important source of concern to their firms. Their concern 
focused on the requirement in No. 8 that translation gains and losses be 
reflected in current income. 



SFAS No. 8: Conforming, Coping, Complaining, and Correcting 41 



A total of 83.3 percent believed that No. 8 misleads management, stock- 
holders, and security analysts because the cost of protection against exchange- 
rate changes is not separately identified, whereas exchange gains and losses 
are highly visible in financial statements.** 

The respondents also agreed strongly (60.3 percent) that they needed a 
more flexible translation method for foreign-currency balance sheets than 
No. 8.** 

Also, 68 percent of the management surveyed believed that SFAS No. 8 
did not allow a satisfactory measure of the total effect of a rate change. And 
there was stronger agreement (over 75 percent) that the translation prac- 
tices of No. 8 do not result in an accurate measure of the actual exposure to 
foreign-exchange risk.** Further, firms claimed that an accounting-based 
measure of exposure following SFAS No. 8 is incomplete in that certain fu- 
ture transactions which are exposed are not recorded as part of the account- 
ing exposure. 

A large number of our respondents (75.7 percent) agreed that SFAS No. 8 
causes American financial management to overemphasize the reported earn- 
ings impact of foreign-exchange gains and losses as compared to other finan- 
cial considerations (e.g., cash flows).** 

The complaints and criticisms of No. 8 may well have led the FASB 
to initiate its research program on the economic consequences of al- 
ready issued financial accounting standards in April 1977. It is note- 
worthy that two of the four projects funded by the board dealt with 
No. 8. 

Additionally, the FASB initiated a postenactment review process on 
FASB Standards Nos. 1 to 12 in May 1978. Firms were invited to sub- 
mit written comments on these statements (those in effect for at least 
two years) and had until August 15 to submit their letters. By October 
15, 205 written comments were received. Some concerned only one 
FASB Standard and others commented on a number of standards. But 
clearly, SFAS No. 8 was the most popular: 176 letters (85.5 percent) 
either directly or indirectly mentioned SFAS No. 8; and 174 of these 
(98.8 percent) were negative on SFAS No. 8 and suggested that it 
should be re-examined by the board. 

In addition to this postenactment review, the board held a "Public 
Meeting-Evaluation Project on SFAS No. 8" in Stamford on January 
12, 1979. Representatives of thirteen firms were invited to attend and 
were given an opportunity to present their main concerns with SFAS 
No. 8 and to interact with the board, the FASB staff, and each other 
on this topic. Further, some potential changes to SFAS No. 8 were pre- 
sented and discussed. 



42 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



CORRECTING SFAS NO. 8 

The controversy, complaints, and criticisms over SFAS No. 8 have led 
the FASB to consider making some changes in it. Although the board 
has committed itself to change No. 8 and has received the SEC's ap- 
proval for this, the form of the change is still unclear. The following 
is a list of possible changes to No. 8 that the board is asking its staff 
to consider: 

1. Expansion or change of disclosure requirements; 

2. Presentation of translation gains and losses on the income statement 
in a manner similar to extraordinary items; 

3. Translation of inventory at the current rate; 

4. Deferral of translation gains and losses in a separate statement apart 
from the income statement; and 

5. Adoption of the current-rate method of translation. 7 

The authors' study obtained the views of exchange risk managers on 
some of these and similar issues : 

Almost 86 percent of the respondents agreed that inventory is ex- 
posed to exchange risk.** This supports the idea of translating inven- 
tory at the current rate. 

More than 46 percent of the management agreed that the best ap- 
proach to deal with foreign-exchange risk is a foreign-exchange re- 
serve established to cushion the effect of foreign-exchange gains and 
losses on the consolidated income statement.** 

A little more than 44 percent of the respondents agreed with the 
notion that exchange gains and losses should be deferred when the 
exchange-rate changes that caused them are considered as temporary.** 

From exhibit 2, it is clear that a small minority of firms in our survey 
were using the current-rate method prior to the issuance of SFAS No. 
8. 

CONCLUSION 

SFAS No. 8 may well appear to future generations of accountants as a 
milestone in modern standard setting. It is a standard of financial ac- 
counting long needed and issued in response to excessive diversity in 
practice. It was issued after a long study by the FASB and after fol- 
lowing its due process procedure. It had a wide impact on firms and 

' "FASB Adds Project to Agenda to Amend Statement No. 8," Journal of Ac- 
countancy (March 1979): 20. 



SFAS No. 8: Conforming, Coping, Complaining, and Correcting 43 



led to controversy. But the board did not react to this controversy in 
a "knee-jerk" fashion; instead, it proceeded in an orderly manner and 
commissioned two outside studies on the impact of SFAS No. 8 and 
provided channels for the comments of those affected by the standard. 
It now appears that all this will lead to a change for the better in No. 
8. And this may go down in the history of accounting standard setting 
as an example of how the process should work. 



A Note on Translation for Interim Accounts 



ANDREW G. PIPER* 

The discussion memorandum on interim financial accounting and 
reporting 1 suggested that "any changes in current practices could 
either dampen or add to the variations in quarterly earnings reported 
under present financial accounting standards." 2 Although it made no 
specific mention of the translation rate, this is clearly one item which 
could cause earnings to fluctuate. SFAS No. 8 3 asked, if practicable, 
"for the effects of rate changes on reported results of operations . . . [to] 
be described and quantified." (par. 33) 

It may be argued that the choice of rate to be used cannot be de- 
cided until we know whether an "integral" or "discrete" view of in- 
terim earnings is being taken. However, firms do have to report and 
have reported in the past, as might be expected, that there is a wide 
range. Examples are cited below. 

UNILEVER 

The results for the quarter and the first nine months and the compara- 
tive figures for 1977 have been calculated at comparable rates of ex- 
change. These are based on £1 = FL4.36 = U.S. $1.91 which were 
the closing rates of 1977. Total concern profit attributable to ordinary 

* Andrew G. Piper is senior lecturer of the Department of Accounting at the 

University of Birmingham, England. 

1 Financial Accounting Standards Board, An Analysis of Issues Related to 

Interim Financial Accounting and Reporting (Stamford, Conn.: FASB, 1978). 

' Ibid., p. i of insert "An Executive Summary of the Discussion Memorandum 

on Interim Financial Accounting and Reporting." 

8 Statement of Financial Accounting Standards No. 8, Accounting for the 

Translation of Foreign Currency Transactions and Foreign Currency Financial 

Statements (Stamford, Conn.: FASB, 1975). 



46 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



capital for the current quarter and first nine months has also been re- 
calculated at the rates of exchange current at the end of September 
1978, being based on £1 = FL4.17 = U.S. $1.98 4 [only revenue ac- 
count, i.e., no balance sheet]. 

REDLAND 

Overseas currency figures for the half year to September 23, 1978, 
have been converted at rates of exchange ruling on that date and the 
figures for the half year to September 24, 1977, and for the year to 
March 25, 1978, have been converted at rates of exchange ruling on 
March 27, 1978. 

SCAPA 

The continuing strength of the pound against the U.S. and Canadian 
dollars has reduced the effect in sterling terms of an increase in North 
American profits. . . . [No figures for this effect.] 

PICC 

Foreign currencies have been translated into sterling at the rates ruling 
at the end of the appropriate accounting period. Movements in ex- 
change rates during 1978 [up to June 6, 1978] have not had a material 
impact on the group results. 

LAMSON 

All conversions in the 1977 figures have been made at the rates of ex- 
change ruling at end of June 1977. By using these rates in place of 
those adopted at December 31, 1976, the sterling value of the profits 
before tax for the half year ended June 30, 1977, is decreased by ap- 
proximately £14,000 and turnover by £762,000. The half year's figures 
for 1976 have been adjusted to reflect the rates of exchange adopted at 
end December 1976. 

BP 

The reported income in sterling is extremely sensitive to movements in 
exchange rates and to the complex reaction these movements have on 
trading conditions. This applies particularly to the U.S. dollar which 
is the main currency in which oil is traded. In the third quarter the 
rate for the U.S. dollar against sterling fell by 12£ against a 30 reduc- 

' Unilever results third quarter and first nine months 1978. 



Translation for Interim Accounts 47 



tion in the corresponding period of 1977. The effect of this fall on the 
translation of income from operations in the United States and dollar 
cash balances in U.K. companies held to meet dollar commitments is 
estimated to have reduced reported income by £43 million in the 
third quarter of 1978. This compares to a reduction of £7 million in 
the corresponding quarter of 1977. 

These amounts can be related to income before taxation of £530 
million and £506 million, or a reported increase of £24 million after 
allowing for £36 million extra reduction or £60 million before this 
fall. 

Another aspect to be considered is the reporting currency adopted 
by the company. Not all companies with overseas assets and earnings 
will be obliged to produce multicurrency statements, but Unilever, for 
example, reports in at least three languages. The interim reports are 
available in American, Dutch, and English and, more relevant for our 
purpose, in dollars, florins, and pounds. The example in Appendix 1 
(English) provides the format used for the three reports. 

The line "Total concern profit attributable to ordinary capital at 
rates of e xchange ruling 31/12/77" showing an increase of +20 per- 
cent for the third quarter of 1978 compared with 1977 is the same for 
all three. The subsequent lines are different, reflecting the effect of the 
difference arising on recalculation of current period results at end-of- 
period rates of exchange. This becomes substantial when considering 
the figure of earnings per share. 



Change 


Change 


third 


nine 


quarter 


months 


(%) 


(%) 


£ +21 


+ 8 


$ +25 


+ 12 


FL+16 


+ 16 



The "bottom line" earnings per share 
compared to similar figures from American 
Dutch 

The problem of comparability is recognized by Unilever in a differ- 
ent manner when the company publishes the provisional results for 
the fourth quarter and year. 

The results and earnings per share for the full year 1977 have been calcu- 
lated at the closing rates for 1977. The 1976 figures for the full year are 
based on the closing rates for 1976. The trends are therefore influenced by 
the change in exchange rates during the year. For comparison purposes, the 
trends have also been shown based on the comparable rates of exchange. 



48 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



1977 


-1976 


1978 


-1977 


At 


At com- 


At 


At com- 


closing 


parable 


closing 


parable 


rates 


rates 


rates 


rates 


(%) 


(%) 


(%) 


(%) 


+ 18 


+ 11 


+ 14 


+ 8 


+ 1 


- 5 


+ 11 


+ 5 


+ 9 


+ 11 


- 2 


+ 8 


- 6 


- 5 


- 4 


+ 5 


+ 5 


+ 11 


+ 8 


+ 8 


-10 


- 5 


+ 5 


+ 5 



in $ Sales to third parties 

Earnings per share 
in FL Sales to third parties 

Earnings per share 
in £ Sales to third parties 

Earnings per share 

Appendix 2 shows how the quarterly results are summarized in the 
annual accounts and report. The presentation draws attention to the 
difference in the figures for earlier quarters caused by the use of end- 
of -quarter rates originally, and the end-of-year ones; there is not very 
much in the case of the third quarter 1978 (shown in Appendix 1) . It 
is also interesting to note that the earnings per share for 1978 was 
higher than for 1977 in pence per 25p share but lower in florins. 

The recent report by Dukes considers the fluctuations that have 
taken place in currency exchange rates on a monthly basis. 5 Particu- 
larly appropriate to quarter interim reports is the fluctuation from 
quarter to quarter. Appendix 3 considers this for the £ sterling/ dollar 
and indicates that during twenty-eight of the thirty-six possible year 
ends between March 31, 1970, and December 31, 1978, there was a 
reversal of an earlier change. In only eight periods of a year were 
the four changes in the same direction. 



CONCLUSION 

Presumably an investor is interested in accounts and dividends and 
share prices in his own currency (or purchasing power) which would 
suggest that the use of closing rates at the interim reporting stage is 
desirable. As with the annual accounts, identification of the effect of 
changing rates should also be disclosed if practicable. Unilever has 
shown that it is practicable to include both on the one statement. There 
is some indication that fluctuations in reported profits would be less if 
the rate(s) used at the end of the previous year were used for the 
interim reports until the next year end. 

' R. E. Dukes, An Empirical Investigation of the Effects of Statement of Finan- 
cial Accounting Standards No. 8 on Security Return Behavior (Stamford, 
Conn.: FASB, 1978). 



Translation for Interim Accounts 49 



APKNDIX 1. 



The Directors of Unilever announce the results for the third quarter and 
for the first nine months of 1978, and the interim Ordinary dividends in 
respect of 1978. 

Exchange rates 

As has been our practice the results for the quarter and the first nine 
months and the comparative figures for 1977 have been calculated at com- 
parable rates of exchange. These are based on £1 = FI.4.36 = U.S. $1.91, 
which were the closing rates of 1977. Total Concern profit attributable to 
ordinary capital for the current quarter and the first nine months has also 
been recalculated at the rates of exchange current at the end of September 
1978 being based on £1 = Fl.4.17 = U.S.$1.98. 

Combined results 



Third 
1978 


quarter 
1977 


Increase/ 
(Decrease 

% 


) 

(£ millions) 


Nine months 
1978 1977 


Increase/ 

(Decrease) 

% 


2,487 


2,282 


+ 9 
+ 20 


Sales to third parties 

— ■ Combined 

— Limited 

— N.V. 

Operating profit 

Non-recurring items 
Concern share of as- 


7,259 


6,828 


+ 6 


1,054 
1,433 


976 
1,306 


3,089 
4,170 


2,922 
3,906 




162-3 


135-4 
3-9 


447-0 
(1-4) 


413-6 
3-9 


+8 


20-3 


14-8 




sociated companies' 
profit before 
taxation 
Income from trade 


56-3 


43-2 




0-6 


0-6 




investments 


11 


1-1 




(12-0) 


(9-8) 


+ 18 


Interest 

Interest on loan 
capital 
Other interest 

Total concern profit 
before taxation 


(35-4) 


(28-7) 




(13-2) 
1-2 


(10-7) 
0-9 


(35-4) 


(33-3) 
4-6 




171-2 


144-9 


467- 6 


433-1 


+ 8 


(73-6) 
(10-0) 


(64-0) 
(7-0) 




Taxation on profit 
of the year: 
Parent companies and 
their subsidiaries ( 
Associated companies 
Taxation adjustments 


207-3)(199-6) 
(28-2) (20-3) 




(0-2) 


(0-6) 




previous years: 
Parent companies and 
their subsidiaries 


(1.5) 


(1-2) 





50 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



APPENDIX 1. (cont.) 







Increase/ 






Increase/ 


Third quarter (Decrease] 




Nine months (Decrease) 


1978 


1977 


% 


(£ millions) 


1978 


1977 % 


(0-1) 


— 




Associated companies 
Outside interests and 


(2-1) 


— 


(6-6) 


(6-1) 




preference dividends 
Outside interests 


(17-0) 


(16-3) 




(5-7) 


(5-2) 


(14-3) 


(13-6) 




(0-9) 


(0-9) 




Preference dividends 
Total concern profit 


(2-7) 


(2-7) 




















attributable to ordinary 










capital at rates of 












exchange ruling 






80- 7 


67-2 


+20 


31/12/77 

Difference arising on 
recalculation of 1978 
results at end Septem- 
ber 1978 rates of 


211-5 


195-7 +8 


0-5 






exchange 

Total concern profit 


0-6 


















attributable to 






812 


67-2 


+ 21 


ordinary capital 

— Limited 


212-1 


195-7 


+ 8 


41-7 


36-8 


110-4 


109-8 




39-5 


30-4 




— N.V. 
Earnings per 25p 


101-7 


85-9 














2186 P 


18-09 


p +21 


of capital 


57-lOr. 


» 52-69p +8 



Source: Unilever results, third quarter and first nine months 1978. 



APPENDIX 2. QUARTERLY RESULTS 







1st 


2nd 


3rd 


4th 








Quarter 


Quarter 


Quarter 


Quarter 


Total year 


Sales to 


third parties 












1978 


£ million 


2,291 


2,486 


2,480 


2,585 


9,842 


% 




23 


26 


25 


26 


100 


1977 


£ million 


2,222 


2,324 


2,282 


2,319 


9,147 


% 




24 


26 


25 


25 


100 


Operating profit 












1978 


£ million 


108 


179 


163 


151 


601 


% 




18 


30 


27 


25 


100 


1977 


£ million 


118 


160 


136 


127 


541 


% 




22 


29 


25 


24 


100 



Translation for Interim Accounts 51 



APPENDIX 2. (cont.) 









1st 


2nd 


3rd 


4th 










Quarter 


Quarter 


Quarter 


Quarter 


Total year 


Profit before taxation 












1978 


£ million 




110 


185 


170 


144 


609 


% 






18 


30 


28 


24 


100 


1977 


£ million 




124 


164 


145 


117 


550 


% 






23 


30 


26 


21 


100 


Profit attributable 


to 












ordinary 


capital 














1978 


£ million 




46 


84 


80 


63 


273 


% 






17 


31 


29 


23 


100 


1977 


£ million 




50 


79 


67 


62 


258 


% 






19 


31 


26 


24 


100 


Earnings 


i per share 














1978 


pence per 


25p 


12.28 


22.56 


21.64 


16.96 


73.44 


florins 


per F1.20 




3.27 


5.99 


5.76 


4.51 


19.53 


1977 


pence per 


25p 


13.41 


21.19 


18.09 


16.78 


69.47 


florins 


per F1.20 




3.89 


6.16 


5.26 


4.88 


20.19 



The published results for each of the quarters of both years have been re- 
calculated at the year-end rates of exchange which have been used for the results 
of the respective years. 

The figures in the table therefore differ from the figures originally published 
for each quarter. 

Quarterly results are published in leaflet form in the English and Dutch 
languages. Shareholders and others wishing to be included in the mailing lists 
for these leaflets should apply to: Information Division, P.O. Box 68, Unilever 
House, London EC4P 4BQ, or to Unilever N.V., Rotterdam. 
Source: Unilever Annual Report and Accounts, 1978, p. 14. 



APPENDIX 3. 

Relative change in exchange rate (expressed as percentage of end of previ- 
ous quarter) 
Quarter to quarter: Last working day in each quarter 



Year 


1st Qtr 


Spot U.S. dollar 
2nd Qtr 


per U.K. pound 
3rd Qtr 


4th Qtr 


Year 


1969 
1970 
1971 


+0.00250 
+ 0.00556 


-0.00147 
-0.00478 
+ 0.00112 


-0.00360 
-0.00305 
+ 0.02719 


+ 0.00755 
+ 0.00243 
+ 0.02684 





52 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



APPENDIX 3. (cont.) 







Spot U.S. dollar 


per U.K. pound 




Year 


1st Qtr 


2nd Qtr 


3rd Qtr 


4th Qtr Year 


1972 


+ 0.02492 


-0.06568 


-0.01011 


-0.02967 


1973 


+0.05519 


+ 0.04210 


-0.06510 


-0.03745 


1974 


+0.03013 


-0.00104 


-0.02865 


+ 0.00729 


1975 


+ 0.02260 


-0.09078 


-0.06450 


-0.00993 


1976 


-0.05313 


-0.06843 


-0.07099 


+ 0.02038 


1977 


+ 0.01063 


+ 


+ 0.01587 


+ 0.09785 


1978 


-0.02919 


-0.0011 


+ 0.06095 


+ 0.03399 



Number of changes analyzed between + and — for company year end at 
end of: 



1st Qtr 



2nd Qtr 



3rd Qtr 



4th Qtr 





- 


+ 


- 


+ 


— 


+ 


— 


+ 




1970 


2 


2 


2 


2 


2 


2 


2 


2 




1971 


2 


2 


1 


3 


- 


4 


- 


4 




1972 


- 


4 


1 


3 


2 


2 


3 


1 




1973 


3 


1 


2 


2 


2 


2 


2 


2 




1974 


2 


2 


3 


1 


3 


1 


2 


2 




1975 


2 


2 


2 


2 


2 


2 


3 


1 




1976 


4 


- 


4 


- 


4 


— 


3 


1 




1977 


2 


2 


1 


3 


- 


4 


_ 


4 




1978 
Summary 


1 


3 


2 


2 


2 


2 


2 


2 




- + 


Total 


4 


1 









2 




2 




5 


1 3 


1 




3 














4 


2 2 


5 




4 




5 




4 




18 


3 1 


1 




1 




1 




3 




6 


4 


1 




1 




1 




- 




3 



Balance sheet items translated at closing rates, long-term loans in particular, 
would have reflected larger changes using actual "end of quarter rate" rather 
than end of previous year rate for subsequent interim periods. 

Source: Bank of England Quarterly Bulletins. 

+ indicates more dollars are required to purchase one pound. 



ASEAN Federation of Accountants: 
A New International Accounting Force 

FREDERICK D. S. CHOI* 



It has been said that the destiny of human affairs in the last quarter of 
the twentieth century will be decided in the Pacific. 1 Supporting this 
contention, Norman Macrae, associate editor of the Economist, writes 
that the period 1775 to 1875 was one of British economic dominance 
based on innovations in steam power and steel-making technology. 
This "British Century" was followed by the "American Century" of 
1875 to 1975. During this period, the United States became the world's 
leading industrial power because of its superiority in automotive, air- 
craft, and computer technology. Today, the American century is evolv- 
ing into what Macrae calls the "Pacific Century" based on (1) the 
remarkable economic achievements of countries such as Japan, South 
Korea, Taiwan, and Singapore, together with the demonstration effects 
of these achievements on the remainder of Asia; (2) the Pacific Basin's 
enormous market potential; (3) China's recent shift toward a new 
pragmatism that will down play ideology in favor of economic develop- 
ment; (4) the growing economic importance of the West Coast of the 
United States relative to the East Coast; (5) further advances in trans- 
portation and communication technology; and (6) the growing eco- 
nomic cohesiveness among neighboring Pacific countries. 2 

* Frederick D. S. Choi is associate professor of accounting and finance at the 
College of Business Administration, University of Hawaii at Manoa. 
1 Based on the comments of Tun Tan Siew Sin, Chairman Sime Darby Holdings, 
Ltd. in a speech presented at the First ASEAN Federation of Accountants Con- 
ference in Manila, November 21-24, 1978; reprinted as "A Role for The Pri- 
vate Sector," Asian Finance (February 1979). 

1 Jiro Tokuyama, "Meeting the Pacific's Promise," Asian Wall Street Journal 
(23 June 1978), p. 4. 



54 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



In terms of this last consideration, Pacific nations today are acutely 
aware that in an interdependent world, no nation can hope to solve all 
of its development problems alone. At the same time, none appears 
ready to embrace the concept of economic globalism. Regionalism is, 
therefore, proffered as a logical compromise between purely national- 
istic and global philosophies. Accordingly, a number of regional eco- 
nomic groupings has been formed, the most notable being the Associ- 
ation of Southeast Asian Nations (ASEAN). However, while ASEAN 
is today a going concern, little is known of the accounting dimensions 
of this regional association. This paper, therefore, examines the emerg- 
ing phenomenon of ASEAN accounting cooperation and its nature, 
purpose, problems, and functional organization, especially with respect 
to the promulgation of regional accounting standards in Southeast 
Asia. It will also explore the implications of this development for (1) 
other regional accounting organizations in the Pacific, and (2) the 
establishment of accounting standards internationally. 

ASEAN — NATURE AND PURPOSE 

In ancient times, the lands that now comprise ASEAN — Indonesia, 
Malaysia, the Philippines, Singapore, and Thailand — were joined by 
land bridges facilitating economic and social interaction. In time, 
these land bridges disappeared and were replaced by nautical routes 
traversed by ships of commerce whose contents, even today, are being 
excavated from archaeological sites throughout the region. These ships 
ceased to sail during the period of colonial domination that began in 
the fifteenth century. During the next four hundred years, the mercan- 
tilist policies of Britain, the Netherlands, and, eventually, the United 
States prevailed. With the rise of nationalism and the political inde- 
pendence movement that has followed, nations of the Southeast Asian 
archipelago are today attempting to renew the land and nautical 
bridges of old through new financial and industrial ties. 

The Association of Southeast Asian Nations was formed just twelve 
years ago to accelerate the economic development of its member coun- 
tries and to promote peace and freedom among the non-Communist 
countries of the region. Underlying this spirit of cooperation was a 
genuine fear that ASEAN members could very well fall like "dominoes" 
to Asian communism. 3 In terms of tangible progress, however, perhaps 
more has been accomplished during the last two years than in the 

8 "Five Nations Draw Closer to An Economic Linkup," Business Week (25 Sep- 
tember 1978), p. 68. 



ASEAN Federation of Accountants 55 



previous ten years of this group's existence. A start has been made in 
stimulating closer regional trade by reciprocal tariff reductions, not 
unlike the European Economic Community, and a movement is now 
underway to establish a free-trade zone in the area. A complementary 
industrial program is also taking shape with the identification of region- 
wide projects being established in each of the member countries. 

This recent flurry of activities reflects a new sense of urgency follow- 
ing heightened Sino-Soviet rivalry in Indochina. The specter of grow- 
ing superpower conflict in the region has convinced ASEAN heads of 
state that a united front based on visible economic strength and co- 
hesion is critical to the long-run stability and neutrality of the region. 
Moreover, in conformity with their commitment to the free enterprise 
system, ASEAN governments are looking to the private sector, both 
within and outside the region, to play a significant role in helping to 
achieve greater regional cooperation and development 

INTERNATIONAL ACCOUNTING DIMENSIONS 

The foregoing discussion suggests that the concept of economic region- 
alism envisioned by the ASEAN countries is premised on expanded 
trade and investment flows. These flows, in turn, necessitate that the 
products of the accounting process travel beyond the confines of a 
single nation. This is where the international accounting problem 
arises. At present, foreign investors must understand and utilize 
locally oriented accounting reports. To insure the continuous flow 
of investment funds from foreign investors, ASEAN enterprises need to 
provide understandable and comparable financial reports so that 
these investors can properly evaluate the risk and return dimensions of 
their contributed capital. Moreover, intraregional joint ventures among 
ASEAN business enterprises are expedited if financial statements pre- 
pared in one ASEAN country are understandable in the context of 
accounting principles and practices in another. 

Currently, accounting principles among the five ASEAN countries 
are by no means uniform. In a larger context, accounting and dis- 
closure norms in the region also vary from those adopted and under- 
stood in countries outside ASEAN. This situation often necessitates the 
costly preparation of multiple sets of financial statements to accom- 
modate accounting diversity. 

Consequently, regional harmonization of accounting and financial 
reporting practices is today being seriously courted by the accounting 
professions in ASEAN. The establishment of a sound basis of financial 



56 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



communication is recognized as the foundation of the financial infra- 
structure necessary to support foreign investment and regional joint 
ventures of the magnitude envisioned by the ASEAN pact. The fact 
that a majority of the ASEAN countries are at similar stages of their 
economic development bodes well for the feasibility of this massive 
harmonization effort. 

OBSTACLES TO HARMONIZATION 

While harmonization of accounting and financial reporting principles 
in ASEAN seems a workable undertaking, the path to harmonization 
will not be a smooth one. Alindada and Casino cite a number of ob- 
stacles to harmonization which are summarized below. 4 

Historical Ties 

As mentioned earlier, ASEAN countries were formerly under foreign 
rule, with Thailand as a notable exception. As a result, accounting 
practices in these countries have been significantly influenced by those 
of the respective "mother countries." Accounting practices in the 
Philippines are largely patterned after those generally accepted in the 
United States. Accounting standards in Malaysia and Singapore re- 
flect the British influence, while Indonesian accounting practices largely 
mirror the influence of the Dutch. Foreign-based multinational com- 
panies (primarily American) are also a growing feature of the ASEAN 
scene. The reporting practices of these companies add yet another 
dimension to accounting norms in Southeast Asia. Finally, accounting 
education systems in ASEAN have also been influenced by historical 
ties. This factor will no doubt continue to perpetuate differences in 
accounting practices in the region. 

Government Laws and Regulations 

Existing laws and regulations of ASEAN governments also impact the 
development of financial reporting standards. National legislation 
affects the types of accounting records to be maintained, the form and 
content of financial statements to be filed, reporting periods to be 
observed, and the manner of recognized revenue and expense for tax 
purposes. Tax laws in certain ASEAN countries, for example, do not 
permit deductions for depreciation on buildings. Consequently, de- 

* Carlos R. Alindada and Jesus A. Casino, "Harmonization of Accounting Prin- 
ciples and Standards," Technical Papers (First AFA Conference and Thirty- 
second PICPA National Convention, Manila, Philippines, November 22-25, 
1978), pp. 43-45. 



ASEAN Federation of Accountants 57 



preciatkm of buildings for financial reporting purposes is likewise un- 
common in these countries, a practice that may be difficult to change. 

Environmental Differences 

Differences in environmental circumstances also promise to complicate 
ASEAN harmonization efforts. Thus, public ownership of corporate 
securities in a country such as the Philippines suggests financial report- 
ing and disclosure principles unlike those applicable to predominantly 
family-owned corporate interests as in Thailand. Similarly, agrarian 
economies such as Indonesia and Thailand may require accounting 
systems differing from those utilized by an economy based largely on 
trade and financial institutions, such as Singapore. 

DIFFERENCES IN ACCOUNTING AND FINANCIAL REPORTING 

The foregoing considerations explain to a large extent the diversity 
within ASEAN in regard to the preparation of annual reports and their 
underlying accounting premises. Before examining organizational 
efforts aimed at reducing such diversity, let us first consider some of 
the basic accounting and financial reporting differences among the 
respective ASEAN countries. 5 

Disclosure Legislation 

Malaysia, Singapore, the Philippines, and Thailand possess national 
regulations requiring the publication of annual financial statements 
by groups or individual companies. While this is not the case for Indo- 
nesia, companies listing their shares on the Indonesian Stock Exchanges 
are required to do so. In both Indonesia and the Philippines, this pub- 
lishing obligation relates to reports of individual companies only. Con- 
solidated statements are not required. The publication of annual fi- 
nancial statements of the parent company as well as consolidated 
financial statements of domestic companies is required in Malaysia, 
whereas in Thailand only annual financial statements of the parent 
company must be disclosed. Singapore stands alone in mandating 
the publication of parent-company as well as consolidated financial 
statements of the worldwide group. This no doubt is due to Singapore's 
role as a leading financial center in the Pacific. 

8 The following analysis draws on data obtained in a recent questionnaire survey 
compiled by the 1978 AFA Committee on Accounting Principles and Standards. 
The author is especially grateful to its chairperson, Mrs. Estela Macuja, for 
making the results of that survey available. 



53 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Financial Statement Principles 

Uniform accounting principles underlying the publication of financial 
statements are present in four of the five ASEAN member countries. 
Thailand, being the exception, follows generally recognized noncodi- 
Ged p rin c ip les; that is. certain accounting concepts are considered so 
fundamental to the reporting process that they are considered manda- 
tor.' by the profession even in the absence of statutory or professional 
pronouncements. 

Professional Involvement in Standard Setting 

Professional accounting associations play an active role in the develop- 
ment of accounting principles in all ASEAN countries. However, de- 
cision-making authority with respect to the promulgation of accounting 
standards is not enjoyed by the Thai accounting profession to the 
same extent as the professions in the other four countries. The profes- 
sions in all five countries are reportedly exerting efforts to harmonize 
local accounting principles on an international basis with Singapore 
impiicity adopting principles prescribed by the International Account- 
ing Standards Committee. 

Application of Accounting Principles and Practices 

Contrasting the application of specific principles and practices in a 
five-nation setting is a major undertaking and exceeds the scope of this 
paper. Therefore, the principles practices chosen for analysis are highly 
selective. It should also be noted that the data analyzed represent the 
responses of national accounting organizations surveyed in each of 
the respective ASEAN countries. The responses reflect the attitudes 
and views of these organizations and simply provide a general overview 
of what is and is not applicable from country to country. 

Consider, first, the area of consolidation principles. In Malaysia., the 
Philippines 'for companies wishing to consolidate . and Singapore, 
ownership of more than 50 percent of the equity capital of an investee 
company is a condition for preparing consolidated financial statements. 
This criterion is employed by only a handful of companies in Indonesia 
and Thailand where consolidated statements are not mandated. Con- 
solidation is also required in Malaysia and Singapore when an investor 
has effective control of an investee even though ownership is less than 
50 percent. Investment in unconsolidated subsidiaries is carried on an 
equity basis by a majority of companies in Malaysia with approximately 
half of the companies in Singapore also adopting this practice. The 
other 50 percent of Singapore companies carry these investments at 



ASE 'AN Federation of Accountants 59 



cost with separate disclosure of the parent company's equity in related 
net assets. Companies in Indonesia and the Philippines also subscribe 
to this practice. 

In accounting for enterprise assets, inventories are carried exclusively 
at cost in Indonesia and Malaysia while the lower of cost or market 
rule is generally accepted in the other three ASEAN countries. Indo- 
nesia stands alone in valuing long-term receivables at their discounted 
present values and recognizing imputed interest income thereon. Un- 
like Malaysia and Singapore, fixed asset depreciation methods for 
financial reporting purposes in Indonesia, the Philippines, and Thailand 
conform strictly to the requirements of tax law. Moreover, companies 
in the Philippines and Thailand do not customarily consider estimated 
salvage value in calculating periodic depreciation charges. 

Interestingly, accounting responses to inflation are not entirely new 
to ASEAN as revaluation of fixed assets in excess of original cost is per- 
mitted in Malaysia. Singapore, and the Philippines. For example, spe- 
cial Bulletin No. 2.71. issued in November 1971 by the Philippine In- 
stitute of CPAs. recommends that companies revalue their assets using 
appraisal values whenever price levels, as measured by a consumer 
price index, increase by at least 25 percent since the last revaluation. 8 
In cases where assets have been revalued, all three countries require 
that the basis of revaluation be disclosed and an owner's equity ac- 
count credited for the amount of the write-up. Malaysia and Singapore 
require that depreciation expense for financial reporting purposes be 
based on the revalued amounts. Although the Philippine Institute also 
encourages such treatment, few companies follow this prescription, as 
depreciation on revalued assets is not yet recognized by the Philippine 
tax authorities. 

With regard to liabilities, discount on bonds payable is usually 
amortized over the term of the outstanding obligation in the Philip- 
pines, Singapore, and Thailand, whereas it is written off in its entirety 
in the year in which it occurs in Malaysia. Long-term lease payments 
are recorded as periodic rental charges in the Philippines and Singa- 
pore, whereas they are capitalized in Indonesia, Malaysia, and Thai- 
land when the substance of the lease arrangement transfers the usual 
risks and rewards of ownership from the lessor to the lesee. While de- 
ferred tax accounting is generally accepted in Malaysia and Singapore. 
this is not the case in die Philippines and Thailand. In Indonesia, tax 

s Philippine Institute of Certified Public Accountants. Generally Accepted As- 
counting Principles: Codi^.caiisn of Accounting Principles Bulletins as of De- 
cember 1977 (Manila, Philippines: PICPA. 1978;.. pp. 135. 143. 



60 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



deferrals owing to timing differences are generally disclosed in foot- 
notes to the financial statements. 

Accounting for owners' equity in ASEAN also offers some interesting 
contrasts. The use of owners' equity reserves to transfer income between 
reporting periods is actually required in Indonesia and Malaysia. Re- 
valuation reserves created following the write-up of fixed assets, men- 
tioned earlier, are not only available for stock dividends in both Ma- 
laysia and Singapore but also for cash dividends in Malaysia! 

Turning now to items of income, while sales and cost of goods sold 
are generally disclosed in four of the five ASEAN countries, one is 
hard pressed to find such disclosures in the income statements of Singa- 
pore companies. And, while earnings per share figures are disclosed in 
Malaysia, the Philippines, and Thailand, only a minority of companies 
do so in Indonesia and Singapore. 

Owing to the fact that most countries in ASEAN are still in the early 
stages of their industrial development, foreign direct investment activi- 
ties by ASEAN companies are not extensive. This no doubt accounts 
for the accounting emphasis on foreign-currency transactions as op- 
posed to the translation of foreign-currency financial statements. In this 
regard, translation losses arising on foreign-currency liabilities incurred 
in relation to the import of inventories are capitalized as part of their 
cost if the corresponding items are unsold when the translation loss 
occurs. 7 This "single transaction" perspective is followed in Indonesia, 
Malaysia, and the Philippines. Similarly, the cost of fixed assets is also 
increased by any translation loss arising on foreign-currency debt in- 
curred for the purchase of the asset, subject to a realization test. About 
one-half of the companies in Thailand also subscribe to this treatment. 
Translation gains and losses on all other unsettled transactions are 
generally taken to income in the period in which they take place. 
Malaysia is reportedly the only exception here. 

As a final contrast, consider the funds statement. A statement of 
changes in financial position is included in the general purpose financial 
statements in only three of the five ASEAN countries — Indonesia, 
Malaysia, and the Philippines. In the former two countries, attention 
is directed primarily to changes in cash or its equivalent. The Philip- 
pine Institute of CPAs, in contrast, adopts a broader view and recom- 
mends that companies disclose all important aspects of financing and 
investing activities regardless of whether cash or other documents of 
working capital are directly affected. 

7 This procedure is generally subject to a lower of cost or market test. 



ASEAN Federation of Accountants 61 



ORGANIZATIONAL EFFORTS TOWARD REGIONAL HARMONIZATION 

Cognizant of the need for a formal structure to consolidate harmoniza- 
tion efforts in the ASEAN region, the representatives of the various 
ASEAN accounting organizations held a series of organizational meet- 
ings beginning in 1976. The result was the formation of the ASEAN 
Federation of Accountants (AFA) on March 12, 1977, in Bangkok, 
Thailand. The major objectives of the Federation as stated in its con- 
stitution are as follows: 

... to provide an organization for the ASEAN accountants for the further 
advancement of the status of the profession in the region with the view to 
establishing an ASEAN philosophy on the accounting profession, ... to estab- 
lish a medium for closer relations, regional cooperation, and assistance among 
ASEAN accountants, and ... to work in cooperation with ASEAN business 
regional groupings whose economic development efforts may be comple- 
mented by ASEAN accountants. 8 

Professional accounting organizations comprising AFA are Ikatan 
Akuntan Indonesia, the Malaysian Association of Certified Public 
Accountants, the Philippine Institute of Certified Public Accountants, 
the Singapore Society of Accountants, and the Institute of Certified 
Accountants and Auditors of Thailand. The Federation is governed by 
a council composed of one representative from each ASEAN country. 
Eugenio R. Reyes, past president of the Philippine Institute of Certi- 
fied Public Accountants and a partner of SGV & Co. and Tan Hee 
Chia, past vice president of the Singapore Society of Accountants and 
group chief accountant of Sime Darby Holdings, Limited, are currently 
serving as president and vice president, respectively, of the Federation 
for 1978-79. The ASEAN Federation of Accountants has been formally 
recognized by the ASEAN Council of Foreign Ministries and repre- 
sents a significant attempt by the private sector to complement the 
efforts of the ASEAN governments in furthering the economic develop- 
ment of the region. 9 

AFA has a permanent secretariat in Manila and has already under- 
taken several programs of professional activity. At the present time, 
AFA has four standing committees: Accounting Principles and Stan- 
dards (chaired by the Philippines), Auditing Principles and Standards 
(Indonesia), Education (Thailand), and Professional Development 

8 From a conference program entitled First AFA Conference and Thirty-second 
PICPA National Convention (Manila, Philippines: ASEAN Federation of Ac- 
countants and Philippine Institute of Certified Public Accountants, November 
22-25), p. 17. 

9 "AFA Is Affiliated with ASEAN," AFA Newsletter (September 1978), p. 1. 



62 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



(Singapore). Most notable to date has been the work of the Account- 
ing Principles and Standards Committee whose charge is to promulgate 
accounting standards applicable to conditions in the ASEAN region. 
The nature and scope of these standards and their authority are dis- 
cussed in AFA's Exposure Draft 1, "Introduction to ASEAN Account- 
ing Standards." This exposure draft, reproduced in the appendix to 
this paper, describes promulgation procedures similar to those followed 
by the International Accounting Standards Committee. Exposure 
Draft 2, "Fundamental Accounting Principles" (also appended), sug- 
gests the following as AFA's approach to regional harmonization. As 
a first step, the Federation has decided to formalize those accounting 
principles and practices common to all countries in the region. Atten- 
tion will subsequently turn to an analysis of divergent accounting prin- 
ciples with the aim of reconciling such differences. 

A recent survey conducted by AFA's Committee on Accounting 
Principles and Standards has identified accounting and reporting simi- 
larities among all ASEAN member countries in at least the following 
areas : 10 

(1) Fundamental concepts — The following fundamental accounting 
concepts are adhered to in all member countries. Accordingly, dis- 
closure of departures from such concepts is necessary. 

(a) going concern 

(b) consistency 

(c) accrual 

(d) prudence 

(e) realization 

(2) Materiality — The relative materiality of items governs their dis- 
closure in financial statements. 

(3) Profit and loss — Net income for the period is clearly designated 
in one amount. 

(4) Accounting change — A change in an accounting estimate is ac- 
counted for prospectively and financial information concurrently pre- 
sented in respect to prior years is not restated. 

(5) Extraordinary items — Extraordinary items are "required" to be 
shown separately from ordinary income and to be included in net in- 
come for the period. 

(6) Income taxes — Provision for income taxes on the current pe- 
riod's profit is shown separately before determining net income. 

( 7 ) Cost of sales — Cost of sales and expenses are appropriately 

10 Alindada and Casino, "Harmonization," pp. 46-47. 



ASEAN Federation of Accountants 63 



matched against sales and revenues and proper cutoff for related items 
is observed. 

(8) Depreciation — Charges to income are made in a systematic and 
rational manner for depreciation of all types of depreciable assets. 

Exposure Draft 2, to be issued as ASEAN Accounting Standard No. 1 
upon approval by AFA's governing council, represents a codification 
of the foregoing concepts together with their specific applications. 

AFA AND IASC 

While the prospects for ASEAN accounting cooperation and harmony 
seem bright indeed, one may rightfully question the appropriateness 
of this endeavor in light of IASC efforts to establish and secure the 
adoption of more global accounting norms. Specifically, will AFA's 
regional efforts prove to be redundant or perhaps even work at cross 
purposes with those of the IASC? Probably not. Although accounting 
may be classified as a profession, an occupation, or even an intellectual 
discipline in its own right, it is above all a service function. As such, 
accounting must respond to the changing needs of a society (or socie- 
ties) and conform to the social, economic, and legal-political mores 
of its environment. If we accept the proposition that accounting en- 
vironments around the world are not the same, then accounting will 
justifiably differ geographically. In a similar vein, accounting standards 
issued by IASC may not always apply to the ASEAN context. As Choi 
and Mueller have observed, 

. . . international standards, as they are slowly emerging through the efforts 
of the International Accounting Standards Committee (IASC) and the in- 
fluence of capital markets as well as other international financial institutions 
and organizations, are really directed at the large multinational enterprises 
rather than at the local small-to-medium size closely-held companies. 11 

As an example, IASC now encourages consolidation of the accounts 
of subsidiaries owned or controlled by a parent company. This practice 
makes good sense for companies whose shares are widely held. This 
condition, however, is not the general case in ASEAN. Similarly, 
IASC's 20 percent ownership test as a condition for use of the equity 
method of accounting for nonconsolidated subsidiaries makes little 
sense in ASEAN countries where the stock of related companies is 
often owned by a few families. 

AFA's efforts, therefore, will no doubt prove to be complementary 

"Frederick D. S. Choi and Gerhard G. Mueller, An Introduction to Multina- 
tional Accounting (Englewood Cliffs, N.J.: Prentice-Hall, 1978), pp. 21-22. 



64 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



to those of IASC rather than competitive. An important function of 
AFA will be to buffer individual ASEAN countries against the whole- 
sale adoption of international accounting pronouncements that may 
not be suitable to local circumstances. More importantly, active par- 
ticipation in the work of IASC and constructive reaction to proposed 
IASC dicta would enable AFA to sensitize the committee to the views 
and concerns of the less industrialized world. 

AFA AND CAPA 

What, then, are the implications of AFA for other international ac- 
counting organizations in the Pacific such as the Confederation of 
Asian and Pacific Accountants (CAPA) ? While one can only specu- 
late in this regard, an examination of CAPA's membership by country 
provides some possible clues. At the present time, CAPA's membership 
consists of twenty-eight professional accounting organizations from 
twenty-one countries in Asia and the Pacific. The sheer size of such an 
organization probably does little to facilitate a spirit of togetherness 
and congeniality among representatives of each of the member organi- 
zations. Coordinating the professional affairs of such a regional ven- 
ture, furthermore, would seem ominous if not a "mission impossible." 
National membership in CAPA also runs the gamut from highly in- 
dustrialized countries such as the United States and Japan to develop- 
ing economies such as India and Sri Lanka. In an organization of 
such size and contrasts, there is the omnipresent danger of some mem- 
bers being "lost in the shuffle." Under such conditions, progress in 
achieving regional cooperation and a coordinated regional accounting 
profession would be slow. When viewed in this context, AFA constitutes 
a natural evolution or "partitioning" of a regional confederation that 
is perhaps too large and varied in its makeup to be fully responsive 
to the needs of all of its national contingents. 

With a new regional organization of its own, will the ASEAN coun- 
tries now withdraw from CAPA? One would hope not as the increas- 
ing interdependence of nations through trade and expanded invest- 
ment flows together with the pervasive influence of multinational en- 
terprises will heighten rather than lessen the need for regional cooper- 
ation in the Pacific. Accordingly, dual membership in both AFA and 
CAPA would seem both necessary and desirable. Should the ASEAN 
five withdraw from CAPA and pursue an independent mode of opera- 
tion, the International Federation of Accountants, whose objective, 
among others, is to encourage and promote the development of re- 



ASEAN Federation of Accountants 65 



gional organization, will have a very significant role to play in coor- 
dinating the activities of these two Pacific Basin accounting federations. 

CONCLUSION 

The ASEAN Federation of Accountants promises to be a constructive 
force in the international accounting standards movement. As a re- 
gional accounting organization, formally recognized by each of the 
ASEAN governments, AFA will play a leadership role in the quest for 
harmonized accounting and reporting standards in Southeast Asia. 
While AFA will undoubtedly benefit from the experiences of the in- 
dustrialized countries in the promulgation of accounting standards, it 
will also serve as a vehicle for tailoring international standards to the 
ASEAN framework. Coordination of harmonization efforts in ASEAN 
and active participation in the formulation of international accounting 
standards will enable AFA to help buffer the mammoth IASC in- 
fluence on its member countries. In so doing, AFA will foster a greater 
sense of confidence within ASEAN and a sense of not being dominated 
by what is often perceived as an extension of the former "mother 
countries." If nothing else, AFA should produce higher visibility and 
social and professional status for independent accountants in Asia. In 
all of these areas, let us wish them well. 

SELECTED REFERENCES 

AFA Newsletter, May and September 1978 issues. 

Carlos R. Alindada and Jesus A. Casino. "Harmonization of Accounting 
Principles and Standards." Technical Papers. First AFA Conference and 
Thirty-second PICPA National Convention. Manila: ASEAN Federation 
of Accountants and Philippine Institute of Certified Public Accountants, 
1978, pp. 41-48. 

Frederick D. S. Choi and Gerhard G. Mueller. An Introduction to Multina- 
tional Accounting. Englewood Cliffs, N.J.: Prentice-Hall, 1978. 

Dr. Utomo Josodirdjo. "Trade and Investment Patterns in ASEAN Nations 
and Their Impact on Multinational CPA Firms." Speech presented before 
the joint meeting of the Washington Society of Certified Public Accountants 
and the University of Washington Faculty, 13 May 1976. 

J. F. McAllister. "ASEAN-American Ties Enter a New Era." Asian Wall 
Street Journal, 17 January 1978, p. 4. 

Indra Mulia. "The Need for an ASEAN Accountants Organization." SGV 
Group Journal (1976) : 25-29; reprinted in Frederick D. S. Choi and Ger- 
hard G. Mueller. Essentials of Multinational Accounting: An Anthology. 
Ann Arbor, Michigan : University Microfilms International, forthcoming. 

Philippine Institute of Certified Public Accountants. Generally Accepted Ac- 



66 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



counting Principles: A Codification of Accounting Principles Bulletins as 
of December 1977. Manila, Philippines: PICPA, 1978. 

Report of the 1978 AFA Committee on Accounting Principles and Stan- 
dards. Manila, Philippines: ASEAN Federation of Accountants, 1978. 

Tun Tan Siew Sin. "A Role for The Private Sector." Asian Finance (Feb- 
ruary 1979): 117-21. 

"South East Asia: Five Nations Draw Closer to an Economic Linkup." 
Business Week, 25 September 1978, p. 68. 

Jiro Tokuyama. "Meeting the Pacific's Promise." Asian Wall Street Journal, 
23 June 1978, p. 4. 



ASEAN Federation of Accountants 67 



APPENDIX: EXPOSURE DRAFTS: ED 1 — INTRODUCTION TO ASEAN ACCOUNTING 
STANDARDS, AND ED 2 — ASEAN ACCOUNTING STANDARD NO. 1: FUNDA- 
MENTAL ACCOUNTING PRINCIPLES 

Committee on Accounting Principles and Standards, ASEAN Federation of 
Accountants 

Foreword 

The Committee on Accounting Principles and Standards of the ASEAN 
Federation of Accountants is responsible, among others, for undertaking 
programs for the continued development of accounting principles and stan- 
dards that are applicable to conditions in the ASEAN region. Initially, the 
Committee prepared and circularized a two-part questionnaire/survey of 
accounting principles and practices in the ASEAN member countries. It has 
compiled the replies to the questionnaire and has analyzed the results of the 
survey. 

The results of the survey highlighted points of agreements and disagree- 
ments in the ASEAN member countries on the principles and practices 
enumerated in the questionnaire. As a first step in harmonizing principles 
and practices in the region, the Committee decided to formalize those princi- 
ples and practices in the questionnaire whose applications are deemed sub- 
stantially similar. Accordingly, the Committee proposes the promulgation by 
the ASEAN FEDERATION OF ACCOUNTANTS of those fundamental 
accounting principles and reporting practices for ASEAN. 

The accompanying exposure draft (ED 2) of an ASEAN Accounting Stan- 
dard (AAS) on fundamental accounting principles prepared by the Commit- 
tee on Accounting Principles and Standards is issued for comment only and 
does not necessarily represent the views of the Committee. The exposure 
draft is based on the questionnaire/survey replies which primarily represent 
the positions and views of the AFA member organizations that prepared the 
replies. Since the fundamental principles and practices set forth in the expo- 
sure draft are limited to those that were enumerated in the questionnaire/ 
survey, the exposure draft does not purport to present a complete listing of 
all principles and practices that are similar in the ASEAN region. The princi- 
ples and practices are necessarily described in general terms and therefore 
do not indicate variations that may be relevant to a particular country. 

The contents of the exposure draft should be studied carefully in the light 
of existing local regulatory and professional requirements and appropriate 
commentaries submitted so that the necessary modifications, revisions or re- 
finements can be incorporated. Comments should be submitted in writing not 
later than January 31, 1979 to the address below: 

Committee on Accounting Principles and Standards 

ASEAN Federation of Accountants 

c/o Philippine Institute of Certified Public Accountants 

P.O. Box 1440 

Manila, Philippines 
If no major comments are received as at January 31, 1979, the draft will be 
finalized in its present form. 



68 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Support to this initial promulgation of the accounting principles by AFA 
is proposed to be along the following approach: 

1 . Following the approval by the AFA Council of the final draft and its issu- 
ance as ASEAN Accounting Standards No. 1, member organizations will 
publish the Standard (which is intended to be consistent with the require- 
ments in the ASEAN region). The publication should contain a statement 
that existing local regulatory or professional requirements are consistent with 
the Standard and, therefore, compliance with local requirements will auto- 
matically assure compliance with such Standard. 

2. The member organizations will exert its [sic] best efforts to include in their 
professional requirements a statement to the effect that if an ASEAN Ac- 
counting Standard is consistent with existing local requirements, compliance 
with local requirements will, in itself, automatically assure compliance with 
AFA pronouncements. 

The proposed approach for support to future promulgation of standards 
by AFA is contained in a separate exposure draft (ED 1 ) -Introduction to 
ASEAN Accounting Standards. 

COMMITTEE ON ACCOUNTING PRINCIPLES AND STANDARDS 

1978 
Estela P. Macuja, Chairperson Carmelita G. Salgado 

Mario T. Bautista Macario G. Sevilla 

Jesus A. Casino Evelyn R. Singson 

Virgilio C. Leynes Romulfo B. Villamayor 

ED 1 — Exposure Draft — Introduction to ASEAN Accounting Standards 

On March 11, 1977, the ASEAN Federation of Accountants (AFA) was 
organized by the national organizations in the ASEAN region to support and 
complement the joint efforts of the ASEAN governments and in the ASEAN 
business and industry to "accelerate the economic growth, social progress 
and cultural development in the region." Because of the varying degrees of 
divergence in background and development of accountancy in the region, 
AFA aims, among others, to enhance the continuous development of the 
accounting profession in the region. 

The Committee on Accounting Principles and Standards is the standing 
committee of AFA responsible for the following: 

1. Undertaking programs for the continued development of accounting 
principles which are applicable to conditions in the ASEAN region. 

2. Providing assistance and technical support to member organizations on 
matters related to the practice of accountancy. 

3. Submitting recommendations on accounting principles and standards to 
the AFA Council for approval. 

As a result of the activities of the Committee to enhance regional stan- 
dards and practices, an exposure draft of a proposed ASEAN Accounting 
Standard (AAS) on a particular subject may be prepared for approval by 
the AFA Council. If approved by the Council, the exposure draft will be 



ASEAN Federation of Accountants 69 



issued to all AFA member organizations. Adequate time will be allowed so 
that proper consideration is given to the draft by the member organizations. 

The Committee will study the comments and suggestions received as a 
result of the exposure and will revise or modify the draft as necessary. If the 
revised draft is approved by the Council, it will be issued as an ASEAN 
Accounting Standard and will be effective on the date specified therein. 

Support to ASEAN Accounting Standards 

Regional principles or standards that may be adopted by AFA are intended 
to enhance the meaningfulness, comparability, and understandability of 
financial statement prepared within the region. If an AFA standard is con- 
sistent with existing local regulatory or professional requirements, compli- 
ance with such requirements will automatically ensure compliance with the 
Standard. If an ASEAN Accounting Standard conflicts with local require- 
ments, it will not override the national/local regulations/requirements. 

Support to the AFA standards should preferably be along the following 
approach : 

1. After issuance by AFA of an ASEAN Accounting Standard, the member 
organizations will publish such Standard, with appropriate comments as 
indicated in the following sections. 

2. If the ASEAN Accounting Standard is consistent with the local regulatory 
or professional requirement, the publication should contain a statement that: 

a) existing local regulatory or professional requirements are consistent 
with the Standard, and 

b) compliance with local requirements automatically ensures compliance 
with the Standard. 

3. If the ASEAN Accounting Standard includes any provisions which either 
impose additional requirements or conflict with local regulatory or profes- 
sional requirements, the publication should indicate the steps intended to be 
taken by the member organization to implement the Standard. The national 
organization should then exert its best efforts to align local requirements with 
the Standard. If this is not possible, the national organization should identify 
those provisions which cannot be so aligned. There will then be non-com- 
pliance with these provisions. The national organization should then work 
for the disclosure of non-compliance with ASEAN standards in the financial 
statements or in the audit report. 

4. The ASEAN Accounting Standard should be given as much publicity as 
possible in the business community, business schools and the business sector 
of the government in the ASEAN member countries to enhance their impact 
on accounting practice in the region. 

Conclusion: 

It is expected that support to the ASEAN Accounting Standards or disclo- 
sure of the extent to which they have not been followed will gradually 
improve the presentation of financial statements in the region and will eventu- 
ally contribute to a proper understanding of financial statements emanating 
from the region. 



70 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ED 2 — Exposure Draft — ASEAN Accounting Standards No. 1, Fundamental 
Accounting Principles 

This Standard deals with the fundamental principles and reporting practice 
that should underlie the preparation and presentation of financial statement 
in the ASEAN region. Financial statements for this purpose is [sic] defined to 
include a balance sheet, income statement or profit and loss account, notes 
and other statements which are identified as part of the financial statements. 
Accounting principles and reporting practices generally differ in varying 
degrees among the ASEAN member nations. Similarities, however, exist with 
respect to certain general concepts and basic disclosure practices. To promote 
ASEAN wide acceptance of these concepts of practices, a need arises to 
formalize and codify them within the region before any attempt is made to 
harmonize the divergent principles and practices. Following are fundamental 
accounting principles recognized by the ASEAN Federation of Accountants. 

Fundamental Principles 

1. Going Concern 

Unless stated otherwise, financial statements should be drawn up on 
the going concern concept, i.e. that the business will continue in opera- 
tion indefinitely. It is assumed that the business will continue operating 
for a period of time sufficiently to carry out its contemplated objec- 
tives, plans, contracts and commitments. 

2. Consistency 

a. It is assumed that accounting methods and practices are consistent 
from one period to another. 

b. Where accounting principles and methods have not been consistently 
applied in the determination of results of operations as between one 
period and another the effect of the change should be disclosed. 

c. A change in accounting principles which is inseparable from esti- 
mates should be accounted for prospectively and financial informa- 
tion currently presented in respect of prior years should not be 
restated. 

d. A change in accounting estimate should be accounted for prospec- 
tively and financial information currently presented in respect of 
prior years should not be restated. 

3. Accrual 

Revenues and costs should be accrued, that is, recognized as they are 
earned or incurred (not when money is received or paid) and recorded 
in the financial statements of the periods to which they relate. 

4. Prudence 

Uncertainties necessarily surround many transactions. This should be 
recognized by exercising prudence in preparing financial statements. 

5. Realization 

Profits on transactions should not be taken up until cash is received 
or collection is assured. 

6. Matching 

Cost of sales and expenses should be appropriately matched against 
sales and revenues. It follows that there should be proper cut-off ac- 



ASEAN Federation of Accountants 71 



counting for inventories, liabilities and costs at the beginning and end 
of each period. 

7. Materiality 

The relative materiality of items should govern their disclosure in 
financial statements. 

8. Historical Cost 

a. Assets, liabilities, income and expenses should be recorded in the 
financial statements on the basis of historical cost which should not 
be restated to reflect changes in the purchasing power of the cur- 
rency unit at a subsequent balance sheet date. 

b. Any variations from the historical cost concept should be disclosed. 

Disclosure 

1 . Adherence to Fundamental Principles 

It is not necessary to disclose in financial statements adherence to the 
following fundamental accounting principles 

a. going concern 

b. consistency 

c. accrual 

d. prudence 

If any of these principle [sic] is not followed, the departure should be dis- 
disclosed. 

2. Accounting principles or methods chosen from two or more available to 
meet a given circumstance should be disclosed in the financial statements. 

Balance Sheet Principles 

1. Receivables 

a. Receivables should be reduced by allowances (provisions) to cover 
possible collection costs or losses in respect of unspecified accounts, in 
addition to specific accounts which on the basis of past experience and 
general business knowledge may prove uncollectible. 

b. Receivables from the following should be shown separately: 

(1) affiliated companies 

(2) officers 

(3) directors 

2. Inventories 

a. Inventories should be carried at cost or market whichever is lower. 

b. The basis for carrying inventories should be disclosed. 

c. The basis of determining the cost of inventories (FIFO, average, LIFO, 
etc.) should be disclosed. 

d. Cost of inventories should include direct material and labor and all 
variable and fixed manufacturing overhead calculated at a level of 
normal capacity. 

e. The definition of "market" need not be consistent for the entire inven- 
tory but may change according to the type of inventory item. Thus 
raw materials at "market" means replacement price; work-in-progress 
and finished goods at "market" means net realizable value. Net realiz- 



72 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



able value is defined as estimated selling price less reasonably predict- 
able costs of completion and disposal and an approximately normal 
profit margin. 
f. A breakdown of inventories by type (finished goods, work-in-progress, 
raw materials, etc. ) should be disclosed. 

3. Investments 

a. Investments in marketable securities classified as current assets should 
be carried at the lower of cost or market value. 

b. Investments classified as long-term which are carried at cost should be 
written down by a provision for any impairment in value. 

c. Where the market value of quoted investments is different from their 
book amount, the market value should be disclosed. 

4. Fixed Assets and Depreciation 

a. Fixed assets 

( 1 ) The basis on which fixed assets are stated should be disclosed. 

(2) Land should be shown separately from other fixed assets. 

(3) Costs of construction of fixed assets should include direct cost of 
labor and material plus an appropriate portion of overhead. 

(4) Costs of construction of fixed assets may include interests on money 
borrowed to finance the construction until substantial completion. 

(5) Fully depreciated assets still in service should not be removed 
from fixed asset and accumulated depreciation accounts. Items no 
longer in service should be removed from the accounts. 

(6) The amount of firm contracts for future capital expenditure, not 
accrued at the date of the financial statements, should be dis- 
closed. 

b. Depreciation 

( 1 ) Charges to income should be made in a systematic and rational 
manner for depreciation of all types of depreciable assets. 

(2) Charges to income for depreciation based on the normal life of 
an asset should be adjusted for earlier economic obsolescence. 

(3) The following should be disclosed: 

(a) the methods used in computing depreciation of major classes 

(b) depreciation charges to income 

(c) amount of accumulated depreciation. 

5. Liabilities 

a. All known liabilities should be recorded regardless of whether their 
definite amount is determinable. 

b. Contingent liabilities of importance should be disclosed. 

c. The following should be disclosed separately: 

( 1 ) accounts and notes payable to affiliates 

(2) accounts and notes payable to officers and directors 

d. Where a liability is secured on the company's assets, this fact should 
be stated. 

6. Long-Term Debt 

The amount outstanding, interest rate and term of the debt should be 
disclosed. 



ASEAN Federation of Accountants 73 



7. Capital (Stockholders' Equity) 

a. The rights and preferences to dividends and to principal should be 
disclosed. 

b. The status of stock options outstanding and changes occurring during 
the period should be disclosed. 

c. Any share of a company's own stock reacquired should be recorded at 
cost and shown as a reduction of stockholders' equity. 

d. Where options or warrants to subscribe for shares in the company are 
outstanding, the period during which the option is exercisable and the 
price to be paid for the shares should be disclosed. 

e. Profits and losses arising from transactions in the company's own cap- 
ital stock should not pass through income. 

f. Capital gains (other than those resulting from transactions in the 
company's shares) should be taken into income. 

g. Reserves 

( 1 ) Reserves should not be used to absorb charges which would other- 
wise be charges against income of current or future years. 

(2) General reserves should not be set up by charges to income. 

(3) The movements in reserves during the period should be disclosed, 
h. Retained earnings 

(1) Restrictions on distributions of retained earnings (because of loan 
agreements, trust deeds or other legal restrictions) should be dis- 
closed. 

(2) Cumulative dividends in arrears should be disclosed. 

8. Other Balance Sheet Items 

a. Intangible assets — intangible assets should be amortized over the 
period estimated to be benefited. 

b. Subsequent events — Events or transactions occurring between the date 
of the balance sheet and the date of the auditors' report which may 
have a material effect on the financial position or results of operations 
of the business should be disclosed or reflected in the financial state- 
ments, as appropriate. 

c. Pledged assets — The nature and extent of hypothecated or pledged 
assets should be disclosed. 

d. Long-term contracts — Provision should be made for estimated losses 
on completion when expectation of loss is discovered. 

e. Purchase contracts — Provision should be made for anticipated losses 
on unexpired purchase contracts. 

f. Lease, lease purchase and instalment transactions — The following 
should be disclosed: 

( 1 ) material rental charges for the year under long-term leases 

(2) commitments — amounts and periods — for future years under 
leases and hire purchase contracts. 

(3) the method of accounting for leases, lease purchase and instal- 
ment transactions. 



74 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Income Statement Principles 

1. Sales and Revenue 

a. Sales, revenue and income should not be anticipated or omitted. Ac- 
cordingly, there must be proper cut-off accounting at the beginning 
and end of each period. 

b. Sales should be accounted for at the time of delivery rather than at 
the time of order. 

c. Sales and other revenue for the period should be disclosed. 

d. Unrealized earnings on sales of real estate should be shown as deferred 
income unless collection is assured. 

2. Cost of Sales 

Cost of sales for the period should be disclosed. 

3. Employee Compensation and Pension 

Pension costs should be provided for currendy over the term of em- 
ployment. 

4. Insurance 

a. Uninsured losses should be charged against income as they occur. 

b. Where a self-insurance account is operated, the financial statements 
should disclose the accounting method adopted. 

5. Research and Development Costs 

Development costs may be deferred and amortized on an appropriate 
basis when the development work and related expenditure are clearly 
identifiable and there are grounds for accepting that such costs will be 
covered by future revenue. 

6. Income Taxes 

a. Provision for income taxes on the current period's profits should be 
shown separately before determining net income. 

b. Income taxes should be charged against results of operations on the 
basis of current income rather than on the basis of when paid. 

7. Extraordinary Items 

a. Extraordinary gains or losses, which are those resulting from events or 
transactions whose recurrence is not a regular feature of the business, 
should be shown separately from ordinary income and included in net 
income for the period. 

b. Amounts which enter into the determination of income but which are 
not extraordinary items should be disclosed when their effects on the 
results of a period is exceptional. 

8. Profit or Loss 

Net income for the period should be clearly designated in one amount. 

Foreign Currency Transactions 

1. The basis of translating foreign currencies should be disclosed. 

2. Importation of inventories 

a. Exchange losses arising on foreign currency liabilities incurred for im- 
portations of items of inventories may be added to the cost of inven- 



ASEAN Federation of Accountants 75 



tones if the corresponding items are unsold when the exchange losses 
arise, subject to a lower of cost and market test. 
b. Exchange losses arising on foreign currency liabilities incurred for im- 
portations of items of inventories should be charged to income as part 
of cost of goods sold if the items have been sold in the period in which 
the exchange losses arise. 

3. Purchase of fixed assets 

The cost of fixed assets may be increased by exchange losses arising on 
foreign currency liabilities incurred for the purchase of the assets, subject 
to a realization test. 

4. Unsettled transactions 

Exchange gains or losses on unsettled transactions may be credited to or 
charged against income in the period in which they arise, no attempt being 
made to match them with specific incomplete transactions. 

Comparative Figures 

Comparative figures for the previous year should preferably be shown in 
the financial statements. 



Internal Performance Evaluation 

of Multinational Enterprise Operations 

HELEN G. MORSICATO and LEE H. RADEBAUGH* 



The development of a set of uniform international accounting stan- 
dards requires substantial interaction among countries and between 
the public and private sector both nationally and internationally. 
Numerous efforts have been made to standardize the financial report- 
ing practices of countries worldwide and die basic underlying ob- 
jectives, standards, and practices that are used to generate financial 
statements. The most recent of these efforts has involved the Interna- 
tional Accounting Standards Committee (IASC) and the International 
Federation of Accountants (IFAC) .* 

Most harmonization efforts have focused on the external users of 
financial statements — primarily shareholders, prospective investors, 
and creditors. This idea was emphasized in the recent Statement of 
Financial Accounting Concepts No. 1 issued by the Financial Ac- 
counting Standards Board (FASB). However, the FASB also recog- 
nizes that "the same accounting system normally accumulates, pro- 
cesses and provides the information whether it is called managerial 

* Helen G. Morsicato is assistant professor of accounting at the University of 
Oregon. 

Lee H. Radebaugh is associate professor of business administration at The 
Pennsylvania State University. 

1 For an excellent summary of the organization and functions of IASC and 
IFAC, see Joseph P. Cummings and Michael N. Chetkovich, "World Account- 
ing Enters a New Era," Journal of Accounting (April 1978): 52-61. 



78 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



or financial or internal or external." 2 Obviously, management is in a 
good position to contribute substantially to the setting of international 
accounting standards. 

In addition, IFAC has demonstrated real interest in upgrading the 
quality of information used by management for decision making. One 
aspect of the twelve-point program developed by IFAC is to "evaluate, 
develop and report on financial management and other management 
accounting techniques and procedures." 3 Thus it makes good sense to 
focus on some of the management accounting dimensions of the multi- 
national enterprise (MNE) . One such dimension is the use of financial 
information to evaluate the performance of foreign subsidiaries and 
their managers. 

Evaluating the performance of foreign manufacturing subsidiaries of 
multinational enterprises engenders many problems. First, there is a 
paucity of adequate performance evaluation systems for appraising sub- 
sidiaries and their managers. Second, there is the issue of translating 
the foreign-currency financial information to parent currency. This 
paper focuses on the interaction of financial statement translation and 
performance evaluation of foreign operations, primarily from the view- 
point of a U.S. -based MNE, although an extension of the ideas could 
be made to MNEs domiciled in countries other than the United States. 

The information used in this paper is part of a much larger study 
focusing on the use of U.S. dollar and local-currency information by 
international division executives (IDEs) in evaluating the performance 
of their foreign subsidiaries and managers. 4 Specifically, the paper will 
(1) document the performance evaluation methods currently used by 
the IDEs; (2) examine the use of U.S. dollar and/or local-currency 
financial information in performance evaluation; (3) identify and dis- 
cuss the rationale of IDEs in utilizing particular performance evalua- 
tion methods and rejecting alternative methods; and (4) identify and 
discuss the reasons given by the IDEs for using U.S. dollar and/or 
local-currency financial information in performance evaluation. 

PERFORMANCE EVALUATION OF THE MULTINATIONAL ENTERPRISE 

Performance evaluation is a critical issue in international accounting. 

' Official Releases, "Statement of Financial Accounting Concepts, No. 1 — Ob- 
jectives of Financial Reporting by Business Enterprises," Journal of Accountancy 
(February 1979): 94. 

* Cummings and Chetkovich, "World Accounting," p. 52. 

' Helen Gernon Morsicato, "An Investigation of the Interaction of Financial 
Statement Translation and Multinational Enterprise Performance Evaluation" 
(Ph.D. dissertation, The Pennsylvania State University, 1978). 



Internal Performance Evaluation of MNE Operations 79 



With the development of the MNE came the extension of the account- 
ing function to record and report intercountry operations. Performance 
evaluation of operations in an international environment is a problem 
area that has evolved with this extension of the accounting function. 

The importance of adequate performance evaluation techniques 
for appraising international operations assumes an added perspective 
when one considers that international resource allocation decisions are 
based upon these evaluations. 5 An extension of this argument is to say 
that performance evaluation techniques employed by an MNE could 
have an international economic impact. 

When one is operating in the realm of the multinational enterprise, 
accounting functions as an important formal source of information 
available to management. The headquarter's management needs this 
information to evaluate the performance of the multinational sub- 
sidiaries and the multinational subsidiary managers. 

Accounting data can provide some of the important dimensions of 
manager and subsidiary performance, but Hopwood suggests that ac- 
countants face many major problems in designing information systems 
for this purpose. 6 First, neither accountants nor managers have de- 
veloped comprehensive measures and standards of performance. There- 
fore, not all of the relevant dimensions of performance are included 
in the accounting reports. Second, "even considering the economic 
aspects of performance, an organization's economic cost function is 
rarely known with precision and an accounting system can only at- 
tempt to approximately represent its complexity." Third, the account- 
ing data may be an inadequate reflection of managerial performance. 
Accounting reports are primarily concerned with representing the out- 
come of the subsidiary's operations. Managerial performance is con- 
cerned with the efficiency of the process resulting in the final outcome. 
There may be factors that affect the reported efficiency of the process 
but which are uncontrollable by the manager. The isolation of these 
factors is a difficult task when one is concerned with domestic opera- 
tions. It becomes even more difficult when one is involved with multi- 
national operations. Fourth, accounting reports emphasize short-term 
performance indices while managerial performance evaluation may be 
more concerned with long-term considerations. The cost of designing 
a system that provides accurate and relevant data is also a constraint 
that must be considered. 



1 Anthony G. Hopwood, "Empirical Study of the Role of Accounting Data in 
Performance Evaluation," Empirical Research in Accounting (1972): 157. 
'Ibid., p. 157. 



80 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Accountants attempt to produce general-purpose reports to serve 
the many varied users of this information. Ideally, it would be better 
for users if accountants could provide a unique set of data for each 
of the purposes it is intended to serve. By attempting to satisfy so 
many purposes and users, the general purpose reports may fail to satisfy 
perfectly the requirements for any single purpose, for instance, the 
appraisal of subsidiary and managerial performance. 7 

It is frequently possible to improve an existing performance evalu- 
ation system, but it is unlikely that an ideal accounting performance 
measurement system will be developed. The present research was un- 
dertaken to obtain more detailed knowledge of why certain accounting 
data are used by the multinational enterprises in evaluating the per- 
formances of their multinational subsidiaries and managers. More spe- 
cifically, the paper focuses on whether translated and untranslated ac- 
counting data are used in a variety of reports by the multinational 
headquarter's management in the evaluation of the multinational sub- 
sidiary, why a particular choice was made, and the factors headquarters 
might consider in using financial data to evaluate performance. 

FINANCIAL MEASURES USED IN PERFORMANCE EVALUATION BY MNEs — 
RESULTS OF PRIOR STUDIES 

Several studies concerned with evaluation and control techniques of 
the MNE have been conducted. This section presents a summary of 
the results of each study. 

The Maurtel Study 

Mauriel examined the nature, scope, and effectiveness of multinational 
performance evaluation and control systems. He found that the fifteen 
giant multinational companies (sales of over $5 billion) that he studied 
placed heavy emphasis on financial controls. They also required their 
subsidiaries to use standard domestic budgeting and financial planning 
techniques. These corporations used the profit or investment center 
concept with increasing emphasis on return on investment as a per- 
formance measure. Mauriel also found that currency differences require 
a careful approach to interpreting the meaning of the overseas divi- 
sion's balance sheet and earnings statement. In most instances, the 
foreign manager was given little control over many decisions made by 
the parent company that would ultimately affect his operating results. 

' Ibid. 



Internal Performance Evaluation of MNE Operations 81 



Mauriel also observed a lack of understanding of and concern for the 
impact of currency fluctuations on performance evaluations. 8 

The Mclnnes Study 

Mclnnes' research entailed a survey of thirty moderately sized multi- 
nationals (sales in the $100 to $300 million range). This study focused 
on the design of financial reporting systems between corporate head- 
quarters and foreign affiliates, and the use by corporate executives of 
reported financial data in the evaluation of its foreign operations. 9 
The research findings strongly supported the notion that there is very 
little difference in the design and implementation of financial reporting 
systems for foreign and domestic operations. 

Mclnnes also found that 17 percent of the corporations required 
their subsidiaries to report only local-currency information; U.S. dol- 
lar information was required from 30 percent; both U.S. dollar and 
local-currency reports were required from 50 percent; and for 3 per- 
cent of the firms, the requirement depended upon the country involved. 

The Financial Executives Research Foundation Study 

The Financial Executives Research Foundation sponsored a study on 
the financial control of multinational operations which was designed 
to codify these methods of financial control currently used by the 
multinational companies. The study carefully reviewed the procedures 
used by thirty-four multinational corporations. Each corporation had 
members in the Financial Executives Institute, and each published 
separate figures in its annual reports for at least some aspect of its 
foreign operations. As many as 94 percent of the companies held their 
subsidiaries responsible for profit performance and used this as a mea- 
sure of performance evaluation. 10 Profit as compared to a profit budget 
was the principal measure of profitability with return on investment 
(ROI) mentioned next. Another conclusion was that an MNE con- 
trol system should measure how well the foreign subsidiary manager 
has managed his operations in light of environmental peculiarities and 
foreign-currency fluctuations. 11 

8 John J. Mauriel, "Evaluation and Control of Overseas Operations," Manage- 
ment Accounting (March 1969) : 36-37. 

'J. M. Mclnnes, "Financial Control Systems for Multinational Operations: An 
Empirical Investigation," Journal of International Business Studies (Fall 1971) : 
12. 

10 Edward C. Bursk et al., Financial Control of Multinational Operations (New 
York: Financial Executives Research Association, 1971), p. 25. 

11 Ibid., p. 43. 



82 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



The Robbins and Stobaugh Study 

The evaluation practices used by the MNE in evaluating foreign oper- 
ations were again studied by Robbins and Stobaugh in 1973. Financial 
executives of 39 MNEs were interviewed, and the published records 
of an additional 150 MNEs were studied. They found that foreign and 
domestic subsidiaries were evaluated on the same basis and that the 
basic measure of performance was a form of return on investment with 
budgets used for supplemental information. The corporations reported 
that no separation between the evaluation of the subsidiary and man- 
ager was recognized. Local-currency financial information was required 
by 44 percent of the firms, U.S. dollar information by 44 percent, and 
both types were required by 12 percent. 12 

These studies demonstrate the following: (1) there was and is now 
little apparent difference between the performance evaluation systems 
employed for domestic and foreign operations; (2) there is no con- 
sistency or uniformity when considering the issue of separating the 
manager's performance from that of the subsidiary; (3) most corpora- 
tions use a subset of return on investment, budgeting, and comparisons 
when evaluating the performance of foreign operations; and (4) cor- 
porations were U.S. dollar-oriented in 1969, 13 more aware of local- 
currency information in 197 1, 14 and split between using U.S. dollar or 
local-currency information in 1970 15 and 1973. 18 

METHODS 

Since knowledge in the area of MNE performance evaluation is still 
in its formative stages, a two-phase exploratory field study was the 
chosen methodology for this investigation. The first phase consisted of 
analyzing the results of a questionnaire, and the second involved inter- 
viewing several of the participating IDEs. 

The Questionnaire 

The questionnaire was designed to obtain information pertaining to 
the performance evaluation practices and the methods of translation 
used by the corporations. The section on performance evaluation was 
developed to gather information on the U.S. dollar and/or local- 

u Sidney M. Robbins and Robert B. Stobaugh, "The Bent Measuring Stick for 

Foreign Subsidiaries," Harvard Business Review (September-October 1973): 85. 

13 Mauriel, "Evaluation." 

" Mclnnes, "Financial Control." 

15 Bursk et al., Financial Control. 

18 Robbins and Stobaugh, "Measuring Stick." 



Internal Performance Evaluation of MNE Operations 83 



currency financial and comparative measures used by the corporations. 
This part included questions relative to the interaction of environ- 
mental peculiarities and the design of the corporation's system of in- 
ternal performance evaluation of foreign operations. 

Environmental peculiarities were included because multinational 
enterprises encounter environmental factors unique to international 
operations. The dominant environmental factor peculiar to all foreign 
operations is that of different national currencies. Unexpected cur- 
rency depreciation and appreciation and internal price-level fluctua- 
tions may cause difficulty in predicting a country's exchange rate. 
Varying rates of interest, multiple systems of taxation, and the in- 
fluence of cultures also have implications for those who design, ad- 
minister, and use performance evaluation systems. 

Subjects 

The questionnaire was mailed to 293 U.S. -based corporations with 
manufacturing subsidiaries abroad which produce basic chemicals or 
manufactured products by predominantly chemical processes. The 
chemical industry was selected for the following reasons: (1) chemical 
manufacturing corporations compete worldwide; (2) there is a great 
variation in their commitments to foreign operations; and (3) the 
availability, proximity, and willingness of chemical corporations to 
participate were substantial and necessary. A single industry was ex- 
amined to facilitate the isolation of variables peculiar to a group of 
corporations having a common characteristic. No prior study has 
focused on the practices of a specific industry. Although there is no 
clear evidence to suggest that MNEs operating in different industries 
would use local-currency and U.S. dollar financial information differ- 
ently, this hypothesis can be examined in future studies. 

After the mailing of the initial and follow-up questionnaires, the list 
of eligible corporations was reduced from 293 to 182. Of that number, 
70 (38.5 percent) completed and returned the questionnaire. Eighty- 
one corporations never responded to either the initial questionnaire or 
the follow-up, and thirty-one admitted that they were eligible to par- 
ticipate but had to refuse because of company policy or due to the 
confidentiality of the requested information. Exhibit 1 provides an 
analysis of the responses of the sample corporations. 

Of the seventy corporations that did respond to the questionnaire, 
thirty-three reported annual foreign sales of less than $100 million; 
twenty- two reported annual foreign sales ranging from $100 to $500 
million; and fifteen reported annual foreign sales of over $500 million. 



84 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 1. Analysis of the Responses of the Sample Corporations 



Number of questionnaires mailed 






293 


Ineligible corporations 






111 


Out of business 
Merged 
Responded NO 




4 

3 

104 




Eligible corporations 






182 


Positive response 

Negative response — company policy 
Negative response — confidential 
No response 




70 

25 

6 

81 




Percent of positive responses to eligible 
corporations 70/182 


38.5% 






Percent of total responses to total possible 
responses 205/286 


71.7% 







Sixty-five corporations have subsidiaries in Europe, fourteen have sub- 
sidiaries in the Middle East, twenty have subsidiaries in Africa, thirty- 
six in Asia, thirty-five in Australia, fifty-five in Latin America, and 
fifty-five in Canada. 

The Interviews 

The analysis of key questions on the questionnaire provided a basis 
for selecting those corporations that would participate in the second 
phase of the field study. An attempt was made to contact corporations 
with opposite policies toward performance evaluation, that is, U.S. 
dollar-oriented versus local-currency oriented, concerned with en- 
vironmental peculiarities versus insensitive to these peculiarities, and 
so forth. This balance enabled the researchers to acquire an in-depth 
explanation from IDEs with different opinions as to why certain ap- 
proaches to performance evaluation were followed and alternatives not 
followed. 

Seventeen corporations were visited personally and an additional six- 
teen were interviewed by telephone. The purpose of these interviews 
was to gain a more thorough understanding of particular responses, to 
highlight the most crucial and timely problems pertaining to perform- 
ance evaluation, and to explore the reasoning behind established per- 
formance evaluation policies of the corporations. 



Internal Performance Evaluation of MNE Operations 85 



RESULTS 

The first part of this section focuses on several aspects of the question- 
naire that deal with local-currency and U.S. dollar financial measures. 
The second part consists of an analysis of the results based on com- 
ments and impressions of IDEs gathered through telephone and per- 
sonal interviews. 

Documentation of Performance Evaluation Methods 

Exhibit 2 summarizes the financial measures used as indicators of 
internal performance evaluation. Profit, return on investment, budget 
compared to actual profits, and budget compared to actual sales are 
the measures used most frequently after translation in U.S. dollars. 
Budget compared to actual profits, budget compared to actual sales, 
and profit are those used most frequently before translation in local 
currency. 

It is interesting to note that the frequency of use of these measures 
changes depending upon whether the measure has been translated to 
U.S. dollars or remains in local currency. For example, the use of 
return on investment varies from 80.0 percent after translation to 52.9 
percent before translation. There is also a fairly large difference in the 



Exhibit 2. Financial Measures Used as Indicators of Internal 
Performance Evaluation 



After 


Before 




translation 


translation 




in U.S. 


in local 




dollars 


currency 




(Percent*-) 


(Percent) 


Financial measures 


81.4 


70.0 


Profit 


80.0 


52.9 


Return on investment (assets) 


78.6 


72.9 


Budget compared to actual profits 


72.9 


72.9 


Budget compared to actual sales 


65.7 


35.7 


Cash-flow potential from foreign subsidi- 
ary to U.S. operations 


48.6 


31.4 


Return on equity 


45.7 


38.6 


Budget compared to actual return on in- 

investment 


34.3 


30.0 


Ratios 


21.4 


18.6 


Residual income 


12.9 


11.4 


Others 



1 These figures represent the percent of the total seventy corporations which report using 
each particular measure. 



86 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 3. Most Frequently Used Performance Evaluation Measures 
as Reported in Several Studies 









Studies 






Financial measures 








Robbins & 




in U.S. Dollars 


Mauriel 


Mclnnes 


FERF* 


Stobaugh 


M or sic at o 


Return on investments 












(assets) 


V 


V 


V 


V 


V 


Profit 


V 




V 




V 


Budgets 




V 




V 




Return on sales 








V 




Budget compared to 












actual sales 


V 




V 




V 


Budget compared to 












actual profit 


V 




V 




V 


Temporal comparisons 


V 


V 




V 


V 


Industry comparisons 


V 











a Financial Executives Research Foundation. 

use of cash-flow potential. However, this difference is probably due to 
the fact that cash-flow potential of a subsidiary in U.S. dollars is far 
more important to a U.S. -based corporation than the cash-flow poten- 
tial in local currency. In every case, except budget compared to actual 
sales in which the percentages of use are both 72.9, the rate of use of 
the after-translation measures is higher than that for the before- 
translation measures. 

In comparison, the Robbins and Stobaugh study showed that the 
two most important measures used by the firms for performance evalu- 
ation purposes were return on investment and the budget, followed by 
return on sales and growth on sales. 17 The Mclnnes study found the 
most frequently used measures to be return on investment, compari- 
sons with plan, and historical comparisons. 18 Mauriel reported that the 
firms he studied employed budgeting, temporal and industry average 
comparisons, return on investment, and, to a lesser extent, sales and 
profit targets. 19 The study sponsored by the Financial Executives Re- 
search Foundation found that profit, return on investment, budget com- 
pared to actual profit, and budget compared to actual sales were the 
measures used most frequently for evaluating the performance of for- 
eign subsidiaries and their managers. 20 (See exhibit 3.) 

" Ibid., pp. 82-83. 

18 Mclnnes, "Financial Control," p. 21. 

19 Mauriel, "Evaluation," p. 36. 

20 Bursk et ah, Financial Control, p. 43. 



Internal Performance Evaluation of MNE Operations 87 



Exhibit 4 shows the percentages for the measures a corporation may 
use as a basis of comparison against the subsidiary's actual balance 
sheet and income statement either after or before translation. Historical 
data of the subsidiary, both after and before translation, are used most 
frequently with tabulated percentages of 65.7 and 72.9, respectively. 
This comparison indicates that the firms have a slight preference for 
local-currency information when making historical comparisons. 

The data appear to indicate, however, a preference for after-trans- 
lation financial statements when comparing a foreign subsidiary to 
domestic subsidiaries and comparing foreign subsidiaries in different 
countries. This is to be expected since comparisons could thus be made 
in a common denominator (the U.S. dollar). It is interesting to note 
that 71.4 percent of the corporations do not attempt to compare foreign 
subsidiary results with other similar manufacturing units of the corpo- 
ration in the same country. This is due primarily to the relatively small 
foreign markets and the use of single-plant production strategies. Com- 
parison with results of competitors is virtually impossible due to the 
lack of externally published data. 



Exhibit 4. Measures Used as a Basis of Comparison for Internal 
Performance Evaluation 



After 


Before 




translation 


translation 




in U.S. 


in local 


Does not 


dollars 


currency 


apply 


(Percent*) 


(Percent) 


(Percent) 



Comparative measures 

14.3 21.4 71.4 Other similar manufacturing units of 

your corporation in the same coun- 
try 

48.6 25.7 31.4 Other similar manufacturing units of 

your corporation in different coun- 
tries 

54.3 30.0 25.7 Other similar manufacturing units of 

your corporation in the United 
States 

65.7 72.9 2.9 Historical data of the subsidiary (i.e., 

prior period balance sheets and in- 
come statements) 

4.3 7.1 4.3 Others 

* These figures represent the percent of the total seventy corporations which report using 
each particular comparison. 



88 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



The corporations were also asked whether financial statements pre- 
sented in terms of U.S. dollars or local currency provide better informa- 
tion for the internal performance evaluation of foreign subsidiaries and 
managers. In response to this question, forty-six IDEs (65.7 percent) 
stated a preference for local-currency information and fifteen (21.4 
percent) preferred dollar information. Nine IDEs (12.9 percent) com- 
mented that it is impossible to choose one or the other as better and 
reported that their corporations consider both when evaluating the 
performance of foreign operations. This response is interesting in light 
of the fact that a slight preference for local-currency information is 
exhibited only in comparing historical data of the subsidiary. 

Sixty-three of the corporations (90.0 percent) reported that they use 
the same basic techniques to evaluate subsidiary performance as they 
use to evaluate manager performance. Various comments were made 
on this issue of separating the manager's performance from that of the 
subsidiary. The two most frequently mentioned techniques for accom- 
plishing this separation were (1) to evaluate the manager strictly in 
his own local currency, and/or (2) to evaluate him based upon only 
his controllable revenues and expenses. 

Sixty-three of the corporations (90.0 percent) also reported that they 
apply the same performance evaluation techniques domestically as 
they do abroad. This is consistent with the Robbins and Stobaugh 
study and the Mclnnes study. For those seven corporations (10.0 per- 
cent) which do not necessarily use identical measures at home and 
abroad, the differences in operating environment and organizational 
structure are prime considerations when evaluating worldwide per- 
formance and prevent the use of identical evaluation measures for all 
subsidiaries. Organizational structure is considered to be an important 
variable because of the effect the structure may have on the control 
function of the MNE. Discussion of this variable is the topic of a future 
paper by the authors. 

All seventy IDEs responded "yes" when asked if budgets are used in 
the performance evaluation process. The budgets are generally pre- 
pared in local currency and then translated into U.S. dollars. Seven 
corporations (10.0 percent) do not translate their budgets and choose 
to use only the local-currency information in performance evaluation. 
In sixty-seven cases (95.7 percent), the budget is prepared by the 
foreign subsidiary manager with final approval from headquarters, 
while in only three cases (4.3 percent) the budget is prepared by the 
home office. 



Internal Performance Evaluation of MNE Operations 89 



Information Pertaining to Performance Evaluation Gathered 
through the Personal and Telephone Interviews 

The second phase of the data collection consisted of completing 
seventeen personal and sixteen telephone interviews with IDEs who 
had completed the original questionnaire. The purpose of these inter- 
views was to explore particular responses more completely, thus en- 
abling the researchers to gather additional data pertaining to per- 
formance evaluation. An in-depth explanation as to why certain ap- 
proaches were followed and alternatives not followed was acquired. 
This section discusses and tabulates in summary form the responses 
to several of the questions which pertain to performance evaluation. 

Each of the thirty-three IDEs was asked to rank in terms of usefulness 
and importance those measures used most frequently for internal per- 
formance evaluation of the foreign subsidiaries and their managers. The 
rankings for the first place are explained as follows: ( 1 ) ten IDEs (30.0 
percent) ranked return on investment as first, (2) nine IDEs (27.0 
percent) ranked budgetary information as first, (3) seven IDEs 
(21.0 percent) reported that the evaluation measures are considered 
as a package without ranks, (4) five IDEs (15.0 percent) ranked profit 
as first, and (5) two IDEs (6.0 percent) ranked local-currency mea- 
sures as first. 

Profit and return on investment in U.S. dollars are considered to be 
objective indicators of investment performance for use by corporate 
headquarters. Return on investment is employed because 

it is straightforward, understandable, company policy, and because there is 
no substitute for this measure when evaluating worldwide company profit- 
ability at a board of directors meeting. 

Return on investment is generally not an important indicator of an 
individual subsidiary's or manager's performance in local currency. 

Budgets of foreign operations are extremely important as perform- 
ance indicators in U.S. dollars and local currency. When evaluating 
the performance of the foreign subsidiary and manager in local cur- 
rency, budgets are the most helpful and important measures used. 
Budgets are used because 

they allow flexibility, subjectivity, individual variance analysis, the incorpora- 
tion of environmental peculiarities, a degree of autonomy to be delegated to 
the subsidiary manager, insight as to future problem areas, and an evaluation 
of the manager based upon the operating costs that he controls. 

When asked if their ranking of measures would change in geo- 
graphic location, product line, or function performed, seven of those 



90 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



questioned (44.0 percent) replied affirmatively. Twenty of those ques- 
tioned (71.0 percent) said that expected ROI also varies with geo- 
graphic location, product line, or function performed. Nineteen of the 
IDEs questioned (76.0 percent) felt that the environmental differ- 
ences can be reflected in a corporation's system of internal per- 
formance evaluation. This is surprising because when questioned in 
person, the IDEs seemed more in favor of integrating environmental 
differences into their performance evaluation systems than their an- 
swers to the mailed questionnaire indicated. 

Apparently the environmental factors are considered by allowing a 
high degree of subjective evaluation to operate within the performance 
evaluation system. Twenty-three (95.8 percent) of the twenty- four 
IDEs questioned on this issue admitted that hard-core quantitative in- 
formation is used to evaluate the subsidiary (the investment), whereas 
the subsidiary managers are likely to be evaluated qualitatively, espe- 
cially if they are operating in a changing environment. A few IDEs 
mentioned that "Due to the environmental considerations and the 
increased distance, more nonfinancial indicators of performance are 
incorporated into the evaluation of foreign operations than domestic." 
Nonfinancial measures of performance are also used to evaluate the 
manager when (1) the government intervenes in the business com- 
munity, (2) the operating currency is unstable, and (3) general eco- 
nomic conditions warrant the use of such measures. 

When comparing financial measures of similar manufacturing units 
of the firm operating in different countries, several IDEs were pessi- 
mistic concerning the usefulness of this information. Their comments 
included the following: "We use U.S. dollar comparisons to pinpoint 
problem areas; however, local currency provides the information neces- 
sary to isolate the real problems," "When the operating environments 
are so different, comparisons really don't mean anything," and "These 
comparisons would only have very general and often misleading appli- 
cation." Efficiency and productivity measures are compared by several 
corporations to avoid comparing strictly financial measures. 

Generally, a meaningful comparison of foreign and domestic sub- 
sidiaries is accomplished by comparing operational levels after transla- 
tion while excluding financial items and the effect of any foreign- 
exchange gain or loss. The same doubts as to the usefulness of these 
comparisons are prevalent. 

Return-on-investment and gross profit margins may be compared in the 
long-run by top management; however, interpretations of these comparisons 
may be invalid because of operating differences. 



Internal Performance Evaluation of MNE Operations 91 



Temporal comparisons are the most popular and thought to be more 
meaningful and useful than any of the previous comparisons. Growth 
ratios, productivity measures, and indicators of improvement from 
previous time periods are used frequently. Comparisons of budgets, 
profits, and liquidity positions are common. One IDE stated that 
"historical comparisons are meaningless when the operating environ- 
ment changes so quickly." This statement does not appear to reflect 
the opinion of the majority. 

None of the corporations is so naive as to think that comparisons 
of any two subsidiaries are valid without considering the circumstances 
of each. Many review local-currency financial statements to become 
aware of environmental peculiarities. Many recognize that comparisons 
of measures such as ROI are meaningless, and therefore compare 
yields or productivity while considering the size and environment of 
the subsidiaries. Many believe all comparisons to be misleading, and 
do not employ these measures when internally evaluating the per- 
formance of subsidiaries and managers. 

The corporations reported no obvious separation of subsidiary and 
manager when evaluating the performance of operations. However, 
the interviews disclosed some very interesting incongruous information. 
The majority of firms will not hold a manager responsible or account- 
able for costs over which he has no control. Most of the comments on 
this issue of accountability are very similar. Some of the comments are 
as follows : 

We allocate uncontrollable costs to all subsidiaries in order to view tke 
profitability of the subsidiary; however, we do not hold a manager responsi- 
ble for these allocated costs. 

We separate non-operating items and try to evaluate a manager based upon 
what he controls. 

You cannot hold a manager accountable without also giving him control. 
The manager does not have control over the environment; therefore, we 
evaluate his performance in local currency; however, subsidiary performance 
is evaluated in U.S. dollars. 

According to these comments, the corporations are separating the eval- 
uation of the subsidiary from that of the manager. 

Given that an IDE did report a preference for either U.S. dollar or 
local-currency financial statements on the original questionnaire, when 
asked why one or the other provided better information for internal 
performance evaluation purposes, the responses were fairly identical 
even though the approaches were different. One IDE answered that 
"U.S. dollar information is more convenient." Many agreed with him; 



92 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



however, others felt that local-currency information was more con- 
venient. Other comments included the following: "Local currency is a 
better indicator of operating performance" in contrast to "U.S. dollars 
reveal the true operating results." "Local currency provides a consistent 
basis for evaluation and prevents distortion" compared to "We use 
dollars for consistency" and "Local-currency information is far more 
understandable" versus "U.S. dollars are understandable and less 
confusing." 

Several IDEs answered that U.S. dollars are used because the cor- 
poration is based in the United States, they have always been a dollar- 
oriented corporation, and they think in terms of dollars. Dollars are 
used by many corporations as a common denominator for comparative 
purposes. These corporations recognize that currency fluctuations are 
uncontrollable and feel that local-currency comparisons are meaning- 
less. Then there are those who believe that either U.S. dollars or local 
currency may be used effectively if you understand translation. 

What is clear from an integrated analysis of the answers reported on 
the questionnaire and the information gathered through interviews is 
that firms are rapidly moving toward an overall preference for using 
local-currency information in performance evaluation. Prior studies 
have shown a trend in this direction. Mclnnes and Mauriel pointed 
out a preference for U.S. dollar information while Robbins and Sto- 
baugh and the Financial Executives Research Foundation found that 
firms used both local currency and U.S. dollars. The present study 
shows a clearer movement toward the use of local currency than prior 
studies have, and actually reports a preference for local-currency in- 
formation by some IDEs. 

SUMMARY AND CONCLUSIONS 

Previous studies, cited earlier, investigated the use of different financial 
measures used in performance evaluation of foreign subsidiaries and 
managers. This study focused on the variety of financial measures used 
and the currency in which the data were prepared — U.S. dollars or 
local currency. 

The MNEs studied use more U.S. dollar information than local- 
currency information when internally evaluating their foreign opera- 
tions, although the majority of the IDEs think that local-currency fi- 
nancial statements provide better information than U.S. dollars for 
the evaluation of subsidiaries and managers. The U.S. dollar financial 
measures employed, in order of popularity, include profit, return on 



Internal Performance Evaluation of MNE Operations 93 



investment, and budgets, whereas the local-currency measures include 
budget and profit. Return on investment in local currency is not a 
popularly used measure. 

Nearly a majority of the corporations use U.S. dollar comparative 
measures in evaluating the performance of foreign operations. Com- 
parisons of historical information are more often calculated in local 
currency than in U.S. dollars. 

A majority of corporations use the same basic technique to evaluate 
subsidiary performance as they used to evaluate manager performance. 
Likewise, a majority of firms apply the same performance evaluation 
techniques domestically as they do abroad. 

Reasons given by the IDEs as to why these particular performance 
evaluation methods are used and why U.S. dollar and/or local-currency 
financial information are used were identified during the personal and 
telephone interviews. This information provided insight into the de- 
velopment of the corporations' systems of performance evaluation and 
the problems that have evolved from these systems. 

Given that a subsidiary operates within a country with a stable cur- 
rency, an evaluation of the subsidiary's performance in either U.S. 
dollars or local currency should be meaningful. It is, however, impor- 
tant to evaluate foreign operations internally in local currency when 
the currency is unstable because of the distortions that occur in trans- 
lating financial and comparative information into U.S. dollars. Today's 
foreign environment is plagued by highly and frequently fluctuating 
currencies; therefore, a foreign subsidiary's performance is more 
clearly reflected by its local-currency operating results. Past and present 
studies have shown that corporations are moving toward using local 
currency for internal performance evaluation purposes. 

Comparisons of the past, present, and future operations of a sub- 
sidiary are far more meaningful and valid if calculated in local cur- 
rency. Comparing either the U.S. dollar or local-currency results of 
subsidiaries operating in different environments is not a worthwhile 
endeavor. To achieve a meaningful comparison, the environmental 
peculiarities of each different operating environment would have to be 
isolated and weighted. This is an all but impossible task. 

There is a problem with universally employing local-currency infor- 
mation for evaluating foreign operations. This problem was frequently 
mentioned during the personal and telephone interviews. It seems that 
high echelon managers do not understand how to interpret subsidiary 
results reported in local currency. These managers also have difficulty 



94 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



understanding and interpreting the effect that foreign-exchange gains 
and losses have on the overall enterprise results. Decision making by 
boards of directors and management headquarters is generally based 
upon U.S. dollar information. If lower-level decision making is based 
upon local-currency information, problems with goal congruency and 
optimization of resources may result. Several corporations are already 
making an effort to minimize these problems by requiring that man- 
agers and directors become familiar with foreign-currency results. 

The corporations recognize the value of using local currency for 
evaluating the performance of their foreign operations. The majority 
believe that local-currency financial statements provide better informa- 
tion than U.S. dollar financial statements for the internal performance 
evaluation of foreign subsidiaries and managers. Many of the indi- 
vidual comments gathered from the personal and telephone interviews 
indicate a clear understanding of the ramifications of refusing to 
change old habits in today's operating environment, that is, refusing 
to change from emphasizing U.S. dollar information to local-currency 
information. 



Multinational Accounting: A Technical Note 



M. A. FEKRAT* 

Restating foreign-currency financial statements in terms of a common 
currency equivalent is crucial for providing a global view of the 
operations of multinational enterprises. Such entities cannot prepare 
consolidated financial statements unless the statements of their various 
subsidiaries are translated into a homogeneous unit of measure in the 
same scale of measurement. 1 

Current practice requires the use of the temporal principle of for- 
eign-currency translation. 2 Under this approach, which was officially 
sanctioned by the Financial Accounting Standards Board (FASB) in 
1975, assets, liabilities, revenues, and expenses are translated in a man- 
ner that does not alter their original measurement bases. 3 Initially 
elaborated by Lorensen to rectify the shortcomings of Hepworth's 
monetary-nonmonetary method, the temporal method has the principal 
advantage of not changing the attribute of the item being measured. 4 
Accordingly, assets and liabilities carried at current values are trans- 

* M. A. Fekrat is associate professor of accounting at the School of Business, 
Georgetown University. 

1 Paul Rosenfield, "General Price-Level Accounting and Foreign Operations," 
Journal of Accountancy (February 1971) : 62. 

2 For a discussion of this and other methods (current-noncurrent, monetary- 
nonmonetary, and the current-rate method), see Frederick D. S. Choi and 
Gerhard G. Mueller, An Introduction to Multinational Accounting (Engle- 
wood Cliffs, N.J.: Prentice-Hall, 1978), pp. 65-71. 

Financial Accounting Standards Board, Accounting for the Translation of 
Foreign Currency Transactions and Foreign Currency Statements, Statement 
of Financial Accounting Standard No. 8 (Stamford, Conn.: FASB, 1975). 

Samuel R. Hepworth, Reporting Foreign Operations (Ann Arbor, Mich.: 
University of Michigan, 1956) ; and Leonard Lorensen, Reporting Foreign 
Operations of U.S. Companies in U.S. Dollars, Accounting Research Study No. 
12 (New York: AICPA, 1972). 



96 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



lated at current rates, and those carried at historical values are trans- 
lated at historical rates. Revenue and expense items, too, are translated 
at exchange rates that prevailed when the underlying transac- 
tions occurred, although average rates may be used as a practical 
approximation. 5 

This paper argues that although the temporal method may be 
conceptually superior to other competing methods, it continues to 
rely on the theoretically objectionable system of exchange rates, pegged 
or floating, to achieve the translation process. Such exchange rates 
would be appropriate only within certain specified bands and often 
require highly restrictive and practically unattainable assumptions. To 
rectify these shortcomings, an alternative measure of translation based 
on a classical economic concept is outlined. The proposed measure has 
a more defensible theoretical footing and is free from the internal 
inconsistencies inherent under the temporal method based on con- 
ventional exchange rates. However, the arguments advanced in this 
paper and the conclusions reached are at best tentative and are offered 
to generate further debate rather than as a definitive treatment of the 
complexities involved. 

CRITIQUE OF THE CONVENTIONAL APPROACH 

The conventional approach of using exchange rates to translate for- 
eign-currency financial statements into a common currency equivalent 
is fraught with conceptual difficulties. To be sure, the sales of a sub- 
sidiary serving a domestic market does not necessarily change every 
time the exchange rate changes, although the conventional approach 
would indicate such a change. This is because the conventional method 
is premised on the parent company perspective instead of a multina- 
tional perspective and assumes "as if" the subsidiary sales revenues 
were converted into the currency of the parent company during the 
period covered by the financial statements. This contradicts the "going- 
concern" assumption of multinational operations and distorts the ac- 
counting data, especially when sales and expense data from different 
countries are compared and consolidated. 

Specifically, conventional exchange rates are theoretically inappro- 
priate as a general-purpose medium of translation of foreign-currency 
financial statements because of the following considerations. First, 
exchange rates between currencies tend to equalize, at best, the prices 
of goods and services that enter into international trade. Multinational 

6 Choi and Mueller, Multinational Accounting, p. 69. 



Multinational Accounting 97 



companies domiciled in different countries may not only derive their 
revenue from domestic markets, but may also use domestically manu- 
factured and consumed goods (which may be mandated by host gov- 
ernments) in their production and revenue-generating operations. To 
the extent that exchange rates do not reflect differences in prices of 
such nontraded goods, translation based on conventional exchange 
rates might result in distorted data. Second, under the existing interna- 
tional monetary arrangements, exchange rates may not even equalize 
the prices of internationally traded goods owing to many factors, in- 
cluding intervention by governments in foreign-exchange markets and 
speculative movements of short-term capital. Third, the conventional 
approach ignores the effects of price-level changes in the translation 
process. 6 In a world where "double-digit" inflation has become a global 
phenomenon, it would be misleading to ignore the relative general pur- 
chasing power of currencies in comparative or consolidated financial 
data. Exchange rates in fact may never reflect the relative purchasing 
power of currencies unless the goods and services traded internationally 
are representative of the goods and services in general purchased within 
each country. 7 

Strictly speaking, the conventional approach would be theoretically 
valid for translation and consolidation purposes only when ( 1 ) relative 
prices of internationally traded goods and nontraded goods are the 
same between countries — that is, a shoeshine costs the same in terms 
of wheat in different countries, and (2) exchange rates equalize the 
prices of traded goods. 8 These two conditions are not likely to prevail 
under realistic conditions and, therefore, using the conventional ap- 
proach to translate multicurrency balance sheet, revenue, and expense 
data into a single currency might not yield theoretically valid results. 9 

To illustrate this point, we will draw on the literature in interna- 
tional economics, especially upon a recent work by Jai-Hoon Yang. 10 

9 Paul Rosenfield, "Price-Level Accounting," p. 60. 

7 Ibid., p. 65. 

8 See Milton Gilbert and Irving B. Kravis, An International Comparison of 
National Products and the Purchasing Power of Currencies (Paris: Organization 
for European Economic Cooperation, 1954); Paul A. David, "Just How Mis- 
leading Are Official Exchange Rates?" Economic Journal (September 1972) : 
979-90; and Robin Barlow, "A Test of Alternative Methods of Making GNP 
Comparisons," Economic Journal (September 1977) : 450-59. 

* American Institute of Certified Public Accountants, Reporting the Financial 
Effects of Price-Level Changes, Accounting Research Study No. 6 (New York: 
AICPA, 1963), pp. 148-49. 

10 Jai-Hoon Yang, "Comparing Per Capita Output Internationally: Has the 
United States Been Overtaken?" Federal Reserve Bank of St. Louis Review 
(May 1978): 8-15. 



98 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Assume the usual free-trade, two-country model: Home Country and 
Foreign Country. Home Country prices its goods in terms of HC and 
Foreign Country in terms of FC. Assume further that productivity in 
Home Country is higher than in Foreign Country so that Foreign 
Country's product of traded and nontraded goods per unit of all inputs 
is M and % of Home Country's, respectively. Under these conditions, 
it follows that any valid measure to translate Foreign Country's product 
in terms of Home Country's must fall between 20 and 80 percent of 
Home Country's product. 

Now consider the hypothetical data in exhibits 1 and 2. The average 
real product is greater in Home Country than in Foreign Country, but 
the level of prices is assumed to be higher in Foreign Country than in 
Home Country. Exhibit 1 assumes relative prices to be the same in 
both countries, but exhibit 2 makes the more realistic assumption that 
relative prices are different. 



Exhibit 1. 


, Average Product and Identical Relative Prices 






Nontraded 


goods 


Traded goi 


yds 




Price Qt. 


Total 


Price 


Qt. 


Total 


Foreign country 
Home country 


FC10 2 
HC 2 10 


FC20 
HC20 


FC5 
HC1 


20 

25 


FC100 
HC 25 


Exhibit 2 


, Average Product and Different Relative Prices 






Nontraded 


goods 


Traded goi 


ids 




Price Qt. 


Total 


Price 


Qt. 


Total 


Foreign country 
Home country 


FC20 2 
HC 2 10 


FC40 
HC20 


FC2 
HC1 


20 
25 


FC40 
HC25 



In exhibit 1, where relative prices between traded and nontraded 
goods are the same, the equilibrium exchange rate would be FC5/HC1 
and Foreign Country's total product (FC 120) would be translated into 
Home Country's currency at FC 120 divided by FC5/HC1 = HC 24, 
or about 53 percent of Home Country's total product. This falls within 
the band indicated in exhibit 1 and would, therefore, be a valid 
measure. If a multinational company has purchased half of For- 
eign Country's nontraded goods (and shows that as expense in its 



Multinational Accounting 99 



income statement), it would be translated as FC 10 divided by 
FG5/HC1 = HC2. 

In exhibit 2, where relative prices between traded and nontraded 
goods are different, the equilibrium exchange rate under free trade con- 
ditions would equalize the prices of traded goods between the countries 
and would be FC2/HG1. Foreign Country's product translated into 
Home Country's currency would be FC 80-^-FC2/HCl = HC 40, or 
approximately 90 percent of Home Country's product. This is outside 
the band of valid measures indicated in exhibit 1, and would, therefore, 
be inappropriate. Assuming that a multinational company consumed 
half of the nontraded goods of the Foreign Country in the course of its 
operations, it would show this at FC 20-^-FC2/HCl = HC 10 on its 
financial statements, which is significantly at variance with the result 
obtained earlier. 

It is apparent that only when (1) relative prices in the two coun- 
tries are the same and (2) exchange rates are determined under free 
market conditions would the use of conventional exchange rates yield 
a theoretically valid measure for intercountry comparisons and transla- 
tion of financial results. The foregoing assumptions are seldom met in 
practice as international productivity differentials and government 
intervention in domestic and foreign trade (via taxes, subsidies, tariff, 
and nontariff measures) distort the exchange rates and cause varia- 
tions in relative prices. From our hypothetical examples above, it is 
evident that, other things being equal, the greater the productivity 
differentials between two countries, the wider would be the band of 
valid exchange rates and the extent of differences in relative prices 
that would be consistent with exchange rates within that band. 11 If it is 
correct, it implies that the use of conventional exchange rates for multi- 
national accounting might be less objectionable between industrial and 
less developed countries than between the industrial countries them- 
selves, where productivity differentials may be less pronounced. 

Even within the band of valid exchange rates as determined by in- 
ternational productivity differentials, the temporal method suffers from 
several internal inconsistencies. This stems from the use of historical 
exchange rates for translating assets and liabilities carried at historical 
values and current exchange rates for those carried at current values. 12 

"Yang (p. 9) assumes a productivity differential of Vi and 34 in the production 
of nontraded and traded goods and establishes a correspondingly narrower 
band of valid exchange rates for intercountry comparisons than that proposed 
in this paper. 
12 Choi and Mueller, Multinational Accounting, p. 69. 



100 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Implied here is the assumption that foreign-exchange losses/gains and 
foreign-currency price changes of items carried at historical values are 
largely offsetting, while there is no such relationship for items carried 
at current values. 13 The latter proposition is hardly plausible inasmuch 
as some items carried at current values (for example, inventories car- 
ried at replacement cost) may actually behave in the same manner as 
those carried at historical values while others (marketable securities) 
may compensate for anticipated exchange losses/gains through changes 
in their rates of return. 14 In fact, the temporal method requires that 
inventories be translated at historical exchange rates if carried at his- 
torical values (LIFO) and at current rates if carried at current 
values. 15 This duality in the treatment of inventories is related to the 
assumption that foreign-exchange gains/losses and foreign-currency 
price changes associated with inventories are offsetting in the one case 
and not offsetting in the other — depending on the accounting method 
chosen to carry the inventories! 16 

A Proposed Alternative 

The disadvantage of the temporal method is its partial application 
to multinational accounting of a classical concept in economics — the 
purchasing-power parity concept. 17 Originally developed by Gustav 
Cassel as a method of determining equilibrium exchange rates among 
nations in the post- World War I years, the concept states that the 
equilibrium exchange rate between two countries is equal to the ratio 
of their prices. 18 Thus, if the price level in Foreign Country is doubled, 
the equilibrium exchange rate between Home Country and Foreign 
Country would be halved. On the other hand, if Home Country's prices 
double and Foreign Country's treble, the exchange rate on Foreign 
Country in Home Country's market would fall from 100 to 66 
percent. 19 

18 Robert Z. Aliber and Clyde P. Stickney, "Accounting Measures of Foreign 

Exchange Exposure: The Long and Short of It," Accounting Review (January 

1975): 45. 

14 Ibid., p. 46. 

" Choi and Mueller, Multinational Accounting, p. 70. 

18 For a discussion of some of the other practical problems, see Joseph E. Con- 
nor, Accounting Reality — Foreign Currency and Inflation Accounting: Pro- 
posals for Reform (New York: Price Waterhouse & Co., 1978). 

" Aliber and Stickney, "Accounting Measures," pp. 45-46. 

14 See Gustav Cassel, Money and Foreign Exchange after 1914 (New York: 
Macmillan, 1923). See also Bela Balassa, "The Purchasing Power Parity Doc- 
trine: A Reappraisal," Journal of Political Economy (December 1964): 584-96. 

19 The more refined version of the purchasing-power concept is stated in relative 
terms. In this form, the concept states that changes in the equilibrium exchange 



Multinational Accounting 101 



By advocating the use of historical exchange rates for items carried 
at historical values, the temporal method assumes the same relationship 
between prices and exchange rates that is entailed in the purchasing- 
power parity concept. 20 While admitting the relevance of the purchas- 
ing-power parity concept to items carried at historical values, the 
temporal method stops short of extending it to items carried at current 
values. It is here proposed that the purchasing-power parity concept be 
applied consistently to all the items, not just to those carried at his- 
torical values. Thus, current purchasing-power parity rates could be 
used to translate items carried at current values and historical purchas- 
ing-power parity rates could be used to translate items carried at 
historical values. As will be shown, the proposed approach resolves the 
major conceptual flaws and inconsistencies of the temporal method 
based on actual foreign-exchange rates. 

The purchasing-power parity concept will first be applied to the 
hypothetcal data in exhibits 1 and 2. The parity rate here is com- 
puted simply as the ratio of the number of units of currency of one 
country to the number of units of currency of the other country re- 
quired to purchase a given set of traded and nontraded goods. The 
results are shown in exhibit 3. In cases both where relative prices are 
identical and where they are different, the resulting measure of parities 
falls within the band of theoretically valid rates specified before. If, 
as assumed in the example, a multinational company purchased half 
of the nontraded goods of Foreign Country, it would translate this 
at FC 20 -J- FC5/HC 1 = HC4 where relative prices are identical, 
and at FC 20-4- FC3.3/HC1 = HC6 when relative prices are different. 
The latter is equal to the arithmetic average of the results obtained 
when conventional exchange rates were used for translation, that is, 
(2+ 10)/2 = 6. 

When the purchasing-power parity concept is applied to current 
monetary items, the results become even more interesting. Assume a 
multinational firm holds FC 10,000 of net monetary assets at time t 
when the purchasing-power parity rate was FC 20 = HC 1 . Assume 
further that the net monetary assets remain unchanged during the ac- 
counting period ending at t 2 , but that the level of prices increased from 
100 to 110 in Home Country and from 100 to 120 in Foreign Country. 

rate are proportional to changes in the ratio of foreign to domestic prices. See 
Harold E. Wyman, "Analysis of Gains or Losses from Foreign Monetary 
Items: An Application of Purchasing Power Parity Concepts," Accounting Re- 
view (July 1976): 545-58. 
20 Aliber and Stickney, "Accounting Measures," p. 45. 



102 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 3. Home Country-Foreign Country Purchasing-Power Parities 

Identical relative prices: 

FC 10 (2) + FC5 (20) FC 120 _ 

HC2 (2) + HC1 (20) ~ HC24 ~ FC5 /HC1 

FC 1 20 -r- FC5/HC 1 = HC 24 
HC 24 -f- HC 45 = 53 percent 

Different relative prices: 

FC20(2) +FC2 (20) FC 80 _ 

HC2(2) + HC1 (20) ~~ HC24 ~ FC3 - 3 /HCl 

FC 80 -*- FC3.3/HC1 = HC 24 
HC 24 -r- HC 45 = 53 percent 



The purchasing-power parity rate at t 2 could be approximated as fol- 
lows: FC 20 X (120/100-*- 110/100) = FC 20 X 1.0909 = FC 21.8182 
= HC1. 21 The net monetary assets at t 2 would be translated at 
FC 10,000 -7- 21.8182 = HC 458.33. However, if we were to main- 
tain our purchasing power in terms of the currency of Home 
Country during the period, we should have the equivalent of 
FC 10,000 -:- 20 = HC 500 X 110/100 = HC 550 at t 2 . The difference 
between HC 550 and HC 458.33 (HC 91.67) represents the total 
amount of the loss for holding foreign-currency monetary assets. This 
loss is composed of ( 1 ) a loss that would have occurred if an equivalent 
amount of monetary assets in HC were held, and (2) a loss from the 
differential rates of inflation between the two countries. 22 These two 
amounts may be computed as follows : 

(1) FC 10,000 X HC1/FC20 X (1.00 - 1.10) = HC 50.00 

(2) FC 10,000 X HC1/FC 20 X ([1.10/1.20] - 1) = 41.67 

Total HC 91.67 

These computations are essentially an extension of the usual price- 
level accounting to a multinational setting. If the monetary assets were 
actually converted into HC, they would be converted at the actual 
exchange rate prevailing at the time of conversion. This would, of 
course, give rise to an additional element of loss or gain, thereby either 
increasing or decreasing the total loss computed above. 

n Wyman, "Foreign Monetary Items." 
M Ibid., pp. 548-49. 



Multinational Accounting 103 



CONCLUSIONS 

Perhaps the most important conclusion that emerges from the analysis 
in this paper is that the conventional temporal method used to measure 
foreign-exchange losses/gains of multinational operations produces 
distorted results. This appears to reinforce the findings of other re- 
searchers in the field. 23 Our proposed approach uses a well-known 
classical economic concept to translate foreign-currency statements 
into a common-currency equivalent and simultaneously results not in 
a measure of foreign-exchange gains or losses, but in a measure of 
purchasing-power gain or loss in a multinational environment. This 
translation methodology seems to be superior to the conventional ap- 
proach conceptually and for sharply delineating the end results. 

It also follows that although the financial statements using the pro- 
posed approach provide significant parameters concerning a firm's 
potential exposure to foreign-exchange losses, the latter should be 
estimated primarily by evaluating other factors including political risks 
and geographcial location that have a more important bearing on 
exposure to exchange lossses. 

u Aliber and Stickney, "Accounting Measures," p. 52. 



Recording and Classifying Transactions 
in the Balance of Payments 

RITA M. MALDONADO* 



The details of recording international transactions in the balance of 
payments have long posed confusing problems for students, instructors, 
and even experts in the field. These problems stem in part from the 
failure to adopt a consistent approach to the double-entry accounting 
system of the balance of payments; without an understanding of its 
double-entry nature, one can neither construct a model balance of 
payments nor fully appreciate the significance of its various deficits 
and surpluses. In addition, the difficulties have been greatly aggravated 
in recent years by the increasing complexity of international payments 
stemming from the growth of multinational firms, including banks, and 
the introduction of new types of international financial instruments, 
such as Eurodollars. 

This paper has two purposes. First, it presents and illustrates two 
simple rules, both familiar from a broader context, which can be uni- 
formly applied in recording virtually any international transaction. 
These two rules are derived from viewing a nation's balance of pay- 
ments as a statement of sources and uses of foreign exchange, analo- 
gous to a standard corporate or sector sources-and-uses-of-funds state- 
ment. The basic principles used in constructing a sources-and-uses-of- 
funds statement are straightforwardly applied to the balance of pay- 
ments, thereby placing balance-of-payments accounting in a familiar 
analytical framework. Second, the paper indicates how various types 

* Rita M. Maldonado is associate professor of finance and economics at the 
Graduate School of Business, New York University. 



106 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



of transactions are classified in the structural categories of the official 
U.S. balance of payments prepared by the Department of Commerce. 

SOURCES AND USES 

The usual textbook presentation of the balance of payments stresses 
(properly) that every international transaction must have two entries, 
a credit ( + ) and a debit ( — ) . Two traditional principles are typically 
invoked for making the entries : ( 1 ) transactions that result in receipts 
from abroad are credits, while (2) transactions that result in payments 
abroad are debits. Thus, U.S. commodity exports are credits because 
we are paid; U.S. imports are debits because we do the paying. 1 

However, it is the essence of balance-of-payments double-entry ac- 
counting that each of these transactions must have a contra, a corres- 
ponding balancing entry, and that is where the confusion begins — 
namely, in how properly to perform a double-entry from a single trans- 
action. In other words, an export credit must have a corresponding 
debit, and an import debit must have a corresponding credit to bal- 
ance the accounts. For example, if an export is paid for by the foreign 
importer sending a check in dollars drawn on an American bank, 
thereby reducing a U.S. bank's liability to a foreigner, then the bal- 
ancing entry is a "capital outflow" debit. 

This brings in the second traditional principle: a reduction in U.S. 
liabilities to foreigners (or an increase in U.S. claims on foreigners) is 
a "capital outflow" and a debit, while an increase in U.S. liabilities to 
foreigners (or a decrease in U.S. claims on foreigners) is a "capital 
inflow" and a credit. In general, the first principle (first paragraphs 
this section) is applied to current-account entries and official monetary 
gold, and the second to capital-account entries. This definition of 
capital outflows and inflows leaves much to be desired, and the rela- 
tionship between a credit in the current account and a debit in the 
capital account is far from clear. 

The traditional explanation of balance-of-payments double-entry 
logic makes the balance of payments appear more singularly unique 
than it is. In fact, as a record of all economic transactions taking place 

1 For some standard textbook presentations of the balance of payments, see 
Herbert G. Grubel, International Economics (Homewood, 111.: Richard D. 
Irwin, 1977); Harry D. Hutchinson, Money, Banking and the United States 
Economy (New York: Appleton-Century-Crofts, 1975); Charles P. Kindle- 
berger, International Economics (Homewood, 111.: Richard D. Irwin, 1973); 
Rita M. Rodriguez and Eugene E. Carter, International Financial Manage- 
ment (Englewood Cliffs, N.J.: Prentice-Hall, 1979); and Robert M. Stern, The 
Balance of Payments (Chicago: Aldine, 1973). 



Recording and Classifying Balance-of-Payments Transactions 107 



between the residents of one country and the rest of the world, it 
amounts to nothing more than a national statement of sources and 
uses of foreign exchange — similar, although not quite identical, to an 
ordinary corporate or sector statement of sources and uses of funds. 2 
The conventional principles involved in constructing a corporate 
sources and uses of funds statement are for the most part applicable in 
constructing a national statement of sources and uses of foreign ex- 
change. From this perspective, the double-entry recording of the 
balance-of-payments transactions fits into a familiar pattern and is 
therefore easier to understand and interpret. 

A standard sources-and-uses-of-funds statement for a corporation is 
derived from its income statement and two balance sheets. The income 
statement yields corporate sources and uses of funds on the current 
account, and the balance sheets produce sources and uses of funds on 
the capital account. For the balance of payments, we do not have the 
convenience of an actual income statement and balance sheets to pro- 
vide the data. Hypothetically, however, as will become clear, if an in- 
come statement were to be drawn recording all of a nation's current 
transactions with the rest of the world, every entry on that income 
statement would appear in the balance of payments — basically, form- 
ing its current account. The entries from the corresponding hypo- 
thetical balance sheets are the ingredients of the capital and official 
settlements accounts. 

In a corporate sources-and-uses-of-funds statement, it is conventional 
to record sources of funds as credits ( + , on the right-hand side) and 
the uses of funds as debits (— , on the left-hand side). The same con- 
ventions are applicable to the balance of payments viewed as a state- 
ment of sources and uses of foreign exchange. Thus, following common 
practice with respect to corporate sources-and-uses statements, the 

* Several previous discussions have referred to the balance of payments as a 
sources-and-uses statement. See especially John P. Powelson, Economic Ac- 
counting (New York: McGraw-Hill, 1955), chs. 21-23. More recently, see 
Norman S. Fieleke, "Accounting for the Balance of Payments," New England 
Economic Review, Federal Reserve Bank of Boston (May /June 1971), and 
What is the Balance of Payments? Federal Reserve Bank of Boston (July 1976) ; 
Lawrence S. Ritter and William L. Silber, Principles of Money, Banking, and 
Financial Markets (New York: Basic Books, 1977), ch. 31; and Rodriguez and 
Carter, Financial Management, ch. 2. 

For the derivation of sources-and-uses statements in general, see Ritter, The 
Flow of Funds Accounts (New York University Institute of Finance, 1968) ; 
Ritter and Silber, Principles, ch. 26; James G. Van Home, Financial Manage- 
ment and Policy (Englewood Cliffs, N.J.: Prentice-Hall, 1977), ch. 26; and 
J. Fred Weston and Eugene F. Brigham, Managerial Finance (New York: Dry- 
den Press, 1978), ch. 3. 



108 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



following two rules may be stated to perform the necessary double 
entry for each international transaction : 

1. Decreases in U.S. assets (real, financial, or services) due to their 
transfer to the rest of the world, and increases in U.S. liabilities to the 
rest of the world are sources of foreign exchange and hence credits 
( + , on the right-hand side) . 

2. Increases in U.S. assets (real, financial, or services) acquired from 
the rest of the world, and decreases in U.S. liabilities to the rest of the 
world are uses of foreign exchange and hence debits ( — , on the left- 
hand side) . 

All transactions — with a few exceptions, to be mentioned later — 
between the residents of a country vis-a-vis the rest of the world can 
be double en tried based on these two rules. 

RECORDING AND CLASSIFYING TRANSACTIONS 

Forty-four hypothetical transactions are described below and, on the 
basis of the two rules just cited, are double entried appropriately in 
exhibit 1, which is purposely designed to illustrate the principles in- 
volved. Every transaction has two parts, (a) and (b), each of which 
is subjected to these two rules to determine whether it is a source ( + ) 
or a use ( — ) of foreign exchange. The nature of the transaction and, 
in some cases, an arbitrary rule imposed by the Department of Com- 
merce determine where each entry belongs within the overall structure 
of the balance-of-payments format. For clarity, the forty-four trans- 
actions have been classified into eight categories consisting of the 
major participants or types in international transactions. In some 
cases, a given transaction could be properly classified under more than 
one category, but for simplicity, each transaction is classified under only 
one category. The eight categories are individuals, business concerns, 
multinational firms, banks and other financial institutions, central 
banks and other official institutions, Eurocurrency and other interbank 
transactions, defense-related transactions, and those transactions related 
to the Organization of Petroleum Exporting Countries (OPEC). In 
the aggregate, all forty-four transactions yield a simplified illustrative 
model balance of payments as shown in exhibit 1. After becoming 
familiar with the way in which the rules work, complex formats such as 
the one currently used by the United States Department of Com- 
merce 3 (see exhibit 2), as well as those used by other institutions, are 

* The United States Department of Commerce has changed the balance-of- 
payments format several times during the last two decades. The most recent 



Recording and Classifying Balance-of-Payments Transactions 109 



understandable and useful. (All transactions are in millions of dollars, 
with the word "millions" assumed.) 

Individuals 

/. (a) An Italian private investor buys $5 worth of computer equip- 
ment from a U.S. manufacturer, (b) Payment is made by the Italian 
firm sending a check denominated in lira to the seller, who exchanges 
it for dollars at his U.S. bank. The U.S. bank, in turn, sends the check 
to its Rome correspondent bank, thereby increasing its lira deposit in 
Italy. 

Part (a) is an export of U.S. goods, which means a decrease in U.S. 
assets and therefore, according to Rule 1, a source ( + ) of foreign ex- 
change. Part (b) is an increase in U.S. financial assets (holdings of 
lira deposits) and is therefore a use ( — ) of foreign exchange or a 
debit. In exhibit 1, (a) appears in the current account at LI; (b) 
appears in the capital account at IV. 1. (The entries in exhibit 1 
are recorded in dollar amounts with the transaction number in 
parentheses. ) 

2. (a) American tourists in Mexico spend $20 for souvenirs, obtaining 
the necessary pesos by cashing travelers checks at a Mexican bank, 
(b) The Mexican bank uses the travelers checks to increase its dollar 
balances in a U.S. bank. 

Part (a) is an increase in U.S. assets, in the form of souvenirs or 
services. It is a use of foreign exchange or a debit ( — ) , posted at 1.2. 
Part (b) is an increase in U.S. liabilities to a Mexican bank. It is a 
source or a credit ( + ) , posted at IV.2. 

3. (a) An American jeweller purchases $55 worth of gold from a 
French private investor and (b) pays for it by drawing on his French 
franc deposit account at a commercial bank in France. 

Part (a) represents a purchase of "nonmonetary" gold or "for in- 
dustrial purposes" gold and will be recorded as an import of merchan- 
dise. It is thus an increase in assets (real assets) and hence a use of 
foreign exchange, a debit ( — ), recorded at 1.1. Part (b) represents 

major change was in 1976. For a discussion of the differences among the last 
two complete formats, see the 1976 "Report of the Advisory Committee on the 
Presentation of Balance of Payments Statistics," Survey of Current Business 
(June 1976) ; the present author's review of same in Journal of Economic 
Literature (June 1977): 555-58; and Robert M. Stern et al., "The Presenta- 
tion of the U.S. Balance of Payments: A Symposium," Essays in International 
Finance, no. 123 (Princeton, N.J.: Princeton University, International Finance 
Section, August 1977). 



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112 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 2. U.S. International Transactions Official Balonce-of-Paymenti 
Format Currently Used 

In millions 
Line (Credits +; debits — ) of dollars 

1. Exports of goods and services + 3,025 

2. Merchandise, adjusted, excluding military 1, 6, 12, 28, 29, 

36 + 1,110 

3. Transfers under U.S. military agency sales contracts 37 + 270 

4. Travel 

5. Passenger fares 

6. Other transportation 

7. Fees and royalties from affiliated foreigners 

8. Fees and royalties from unaffiliated foreigners 

9. Other private services 

10. U.S. government miscellaneous services 
Receipts of income on U.S. assets abroad: 

11. Direct investment + 1,325 

12. Interest, dividends, and earnings of unincorporated 

affiliates 11, 14 

13. Reinvested earnings of incorporated affiliates 15 

14. Other private receipts 10 

15. U.S. government receipts 

16. Transfers of goods and services under U.S. military grant 

programs, net 39 

17. Imports of goods and services 

18. Merchandise, adjusted, excluding military 3, 4, 5 

19. Direct defense expenditures 38 

20. Travel 2 — 20 

21. Passenger fares 

22. Other transportation 8 — 50 

23. Fees and royalties to affiliated foreigners 

24. Fees and royalties to unaffiliated foreigners 41 — 450 

25. Private payments for other services 

26. U.S. Government payments for miscellaneous services 
Payments of income on foreign assets in the United States: 

27. Direct investment — 310 

28. Interest, dividends, and earnings of unincorporated 

affiliates 30 — 310 

29. Reinvested earnings of incorporated affiliates 

30. Other private payments 

31. U.S. government payments 

32. U.S. military grants of goods and services, net 39 — 240 

33. Unilateral transfers (excluding military grants of goods and 

services), net — 460 

34. U.S. government grants (excluding military grants of goods 

and services) 40 — 230 



+ 1,160 


+ 


165 


+ 


80 


+ 


240 


— 


2,810 


— 


1,305 


— 


435 



Recording and Classifying Balance-of -Payments Transactions 1 13 



Exhibit 2 (cont.) 



35. U.S. government pensions and other transfers 29 — 110 

36. Private remittances and other transfers 9 — 120 

37. U.S. assets abroad, net (increase/capital outflow [— ]) — 1,905 

38. U.S. official reserve assets, net + 160 

39. Gold 24 - {27 + 28) + 45 

40. Special drawing rights 25, 26 — 320 

41. Reserve position in the International Monetary Fund 

42. Foreign currencies (23 + 38) —23 + 435 

43. U.S. government assets, other than official reserve assets, net 

44. U.S. loans and other long-term assets 

45. Repayments on U.S. loans 

46. U.S. foreign currency holdings and U.S. short-term assets, net 

47. U.S. private assets, net — 2,130 

48. Direct investment — 1,185 

49. Equity and intercompany accounts 33 — (12 + 13 + 

14) — 1,020 

50. Reinvested earnings of incorporated affiliates 15 — 165 

51. Foreign securities 22 — 470 
U.S. claims on unaffiliated foreigners reported by U.S. 

nonbanking concerns: 

52. Long-term 7 — 6 

53. Short-term 10,31 — 145 
U.S. claims reported by U.S. banks, not included elsewhere: 

54. Long-term 21 — 550 

55. Short-term (3 + 5 + 9) - (1 + 7 + 19-20) + 220 

56. Foreign assets in the United States, net (increase/capital 

inflow [ + ]) + 1,995 

57. Foreign official assets in the United States, net + 415 

58. U.S. government securities + 280 

59. U.S. Treasury securities 

60. Other (2, 18, 21, 22, 25, 27, 40, 41) - (2 24, 36, 37, 

42, 43) + 280 

61. Other U.S. government liabilities 

62. U.S. liabilities reported by U.S. banks, not included 

elsewhere 

63. Other foreign official assets 43 +135 

64. Other foreign assets in the United States, net + 1,580 

65. Direct investment + 1,090 

66. Equity and intercompany accounts 30, 42, 44 + 1,090 

67. Reinvested earnings of incorporated affiliates 

68. U.S. Treasury securities 16, 17 + 270 

69. U.S. securities other than U.S. Treasury securities 

U.S. liabilities to unaffiliated foreigners reported by U.S. 
nonbanking concerns: 



1 14 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 2 (cont.) 

70. Long-term 

71. Short-term 34 + 540 
U.S. liabilities reported by U.S. banks, not included 

elsewhere : 

72. Long-term 

73. Short-term (2, 4, 8, 13, 19, 20, 31, 32,35) - (2/7, 

16, 17, 18, 32, 33, 34, 35, 44) — 320 

74. Allocations of Special Drawing Rights 26 + 220 

75. Statistical discrepancy (sum of above items with sign reversed) 

Memoranda: 

76. Balance on merchandise trade (lines 2 and 18) — 195 

77. Balance on goods and services (lines 1 and 17) +215 

78. Balance on goods, services, and remittances (lines 77, 35, 36) — 15 

79. Balance on current account (lines 77 and 33) — 245 
Transactions in U.S. official reserve assets and in foreign 

official assets in the United States: 

80. Increase ( — ) in U.S. official reserve assets, net (line 38) + 160 

81. Increase ( + ) in foreign official assets in the United States 

(line 57 less line 61) + 415 

This format appeared in the Survey of Current Business in June 1978 for the first time. It 
differs from that used from June 1976 to March 1978 only in that it includes reinvested 
earnings of incorporated foreign affiliates of U.S. direct investors and of incorporated U.S. 
affiliates of foreign direct investors. 



a decline in private liquid claims held by Americans abroad. It is thus 
a decrease in the private sector's financial assets and hence a source of 
foreign exchange, a credit ( + ) , recorded at IV. 1. 

Business Concerns 

4. (a) A U.S. wholesaler buys $760 worth of transistor radios from 
Japan, (b) Payment is made by the American wholesaler sending a 
check denominated in dollars to the Japanese seller, who exchanges 
it for yen at his bank in Japan. The Japanese bank, in turn, sends the 
check to its U.S. correspondent bank, thereby increasing its dollar 
deposits in the United States. 

Part (a) is a U.S. import of goods, which means an increase in U.S. 
assets and therefore, according to Rule 2, a use ( — ) of foreign ex- 
change. Part (b) is an increase in U.S. liabilities to Japan — deposits 
are liabilities of the U.S. bank — which, according to Rule 1, is a 
source ( + ) of foreign exchange. In exhibit 1, (a), the import debit, 



Recording and Classifying Balance-of-Payments Transactions 115 



appears in the current account at 1.1; (b), the increase in short-term 
liabilities to foreigners' credit, appears in the capital account at IV.2. 

5. (a) A U.S. retailer buys $490 worth of diamonds from South Africa, 
(b) Payment is made by the retailer via a money order denominated 
in rands purchased at his U.S. bank (the U.S. bank maintains a de- 
posit denominated in rands at a South African bank). 

Part (a) is the same as the previous transaction; it is an increase in 
U.S. assets and therefore a use ( — ) of foreign exchange. Part (b), 
however, is different; payment is made not by an increase in U.S. lia- 
bilities but by a reduction in U.S. financial assets. When the U.S. bank 
sells rands to the U.S. importer, it draws on its account at the South 
African bank, so that the U.S. bank's holdings of foreign funds (rands) 
decline by $490. According to Rule 1, a decline in assets held by U.S. 
residents is a source of foreign exchange and a credit ( + ) . In exhibit 
1, (a) again appears at 1.1, but this time (b) appears in the capital 
account at IV. 1. 

6. (a) An American exporter sells $15 in merchandise (b) on dollar- 
denominated open-book credit to a German importer. 

Part (a) is an export. A decline in U.S. assets is a source, a credit 
( + ), and is recorded at 1.1. Part (b) is a short-term claim, an ac- 
count receivable, held by the U.S. exporter against the German cus- 
tomer. Thus it is an increase in a U.S. financial asset, a use, a debit 
( — ), and is recorded at IV. 1. 

7. (a) & (b) The U.S. exporter above gives its U.S. bank the account 
receivable for collection. 

When this occurs, the exporter's accounts receivable from foreigners 
declines. This is a source and a credit ( + ), recorded in IV. 1. The 
U.S. bank receiving the account receivable for collection now has a 
short-term claim on the German importer, which is commonly re- 
ferred to as a bank collection. This is an increase in U.S. assets and a 
use of foreign exchange, a debit ( — ), recorded at IV. 1. Note that if 
transactions 6 and 7 are combined, the net entries remaining are the 
export credit at 1.1 and the bank collection short-term claim debit at 
IV. 1. However, sometimes either both the bank and the corporation 
report the same account receivable to the United States Treasury 
Department, 4 or the latter fails to report its cancellations; there will 

* The United States Treasury Department collects most of the capital account 
data as well as the interest and dividend income data for the current account 
from financial institutions and corporations engaged in international transac- 
tions. The Treasury then supplies the data to the Balance of Payments Division 
of the Department of Commerce. 



1 16 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



then be double counting of debits, forcing the creation of an error and 
omissions credit (in Part V of exhibit 1 ) . 

8. (a) The U.S. import of radios from Japan described in transaction 
4 requires transportation involving freight charges of $50. A Greek 
vessel is used to transport the radios, (b) Payment is made to the 
Greek shipping line by the U.S. importer with a check drawn in dollars 
on a U.S. commercial bank. 

Part (a) is an increase in intangible assets (services) and via Rule 
2 is a use ( — ) of foreign exchange, posted in exhibit 1 at 1.4. Part (b) 
is an increase in U.S. liabilities to foreigners and thus, via Rule 1, a 
source ( + ) , entered at IV.2. The dollar check paid to the shipowner 
will probably be exchanged for drachma deposits at his own bank 
in Greece, and the Greek bank in turn will most likely send the check 
to the U.S. to be credited to its account at a U.S. bank. It is this end 
result that is reflected in the balance of payments. 

9. (a) A U.S. corporation donates $120 to the Italian organization in 
charge of the restoration of Venice, (b) Payment is made by drawing 
on the U.S. firm's lira deposits held at an American bank's branch in 
Italy. 

This is one of the four types of international transactions in which 
either part (a) or (b) fails to fit the rules and therefore an arbitrary 
decision must be made as to how to record it in the balance of pay- 
ments. The four are those involving (1) unilateral transfers and 
grants, (2) allocations of Special Drawing Rights (SDRs) by the 
International Monetary Fund (IMF), (3) interest and dividends pay- 
ments/receipts, and (4) U.S. official purchases of domestically mined 
gold. This transaction, as well as transactions 10, 11, 14, 15, 26, 28 to 
30, and 39 to 41, illustrates the ways in which these four exceptions 
to the rules are treated. Part (b) of this transaction fits Rule 1 in 
that it represents a decline in U.S. financial assets (namely lira de- 
posits), and hence it is a source ( + ) of foreign exchange entered in 
exhibit 1 at IV. 1. But (a) fits neither rule: it does not represent an in- 
crease or a decrease in either assets or liabilities. Arbitrarily, unilateral 
transfers such as gifts and donations are considered uses ( — ) of 
foreign exchange and recorded in exhibit 1 at 11.1. (One could possibly 
force unilateral transfers of this kind into Rule 2 by reasoning that such 
spending buys an intangible asset, such as goodwill.) 

10. (a) A U.S. corporation receives an $80 increase in its deposits 
in a Brussels bank, (b) as payment of interest on its portfolio invest- 
ments in Belgium. 



Recording and Classifying Balance-of -Payments Transactions 117 



Part (a) is clearly an increase in U.S. assets abroad and by Rule 2 is 
a use of foreign exchange or a debit ( — ); it is recorded at IV. 1. But 
part (b) poses problems, since it does not represent an increase or a 
decrease in either assets or liabilities. Arbitrarily, the receipt of interest 
and dividends is recorded as a source of foreign exchange, a credit 
( + ), at 1.3. One could "force" the receipt of interest and dividends 
into Rule 1 by assuming that before these assets were transferred from 
Belgium to the United States, the U.S. corporation actually held them 
abroad. Hence, when the transfer occurs, it represents a decline in as- 
sets held abroad. Alternatively, those familiar with the actual con- 
struction of a statement of sources and uses of funds will recognize that 
dividends, interest, and royalty payments may be directly considered 
uses without associating these with changes in levels of assets or lia- 
bilities. Similarly, dividends, interest, and royalty receipts may be di- 
rectly considered sources without relating them to changes in levels of 
assets and liabilities. 

//. (a) A U.S. multinational corporation receives $570 in dividends on 
its direct investment in France, (b) with payment made in dollars by 
drawing on the French firm's deposits at a U.S. bank. 

Part (a), the receipt of interest, is recorded arbitrarily as a source, 
a credit ( + ), at 1.3. Part (b), the form that the payment takes, repre- 
sents a decline in U.S. dollar liabilities to foreigners. As such it is a 
use, a debit ( — ) , recorded at IV.2. 

Multinational Firms 

12. (a) A U.S. multinational corporation expands its direct investment 
abroad by installing $480 worth of machinery in its plant in Vene- 
zuela, (b) The machinery is shipped directly to Venezuela from the 
parent company in Florida. 

Part (a), an example of direct foreign investment, represents an 
increase in U.S. -owned assets held abroad. 5 It is recorded as a use 
( — ) of foreign exchange, based on Rule 2, and entered on exhibit 1 
at III.l. Part (b) shows how the asset is "paid for" by an export of 
goods (payment in kind) ; as an export, it is a source ( + ), entered 
in the current account at 1.1. 

13. (a) An American multinational corporation lends $150 for six 

6 According to the rules of the Department of Commerce, direct foreign invest- 
ment abroad is defined as U.S. ownership of 10 percent or more of a foreign- 
based enterprise. Similarly, direct foreign investment in the United States is 
defined as foreign ownership of 10 percent or more of a U.S. -based enterprise. 



118 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



months to its subsidiary abroad. (b)The subsidiary uses the dollars to 
pay a French supplier who in turn deposits the dollars in a Eurodollar 
account at a U.S. bank's branch in France. (It could also be a French 
Eurodollar bank or any other European Eurodollar bank.) 

The loan from parent to subsidiary abroad, part (a), is an increase 
in claims on "foreigners" and for balance-of-payments purposes, this 
increase in financial assets is classified as direct foreign investment. 6 It 
is a debit ( — ) and recorded at III. 1 . Part (b) ultimately implies an 
increase in liquid liabilities of U.S. banks to foreign banks. An increase 
in a liability is a source of foreign exchange and a credit ( + ), re- 
corded at IV.2. (See Appendix A.) 

14. (a) An American corporation's earnings of $590 from its non- 
incorporated foreign branch in Germany (b) are left in that country 
for reinvestment in the branch. 7 

Part (a), the receipt of income, is arbitrarily recorded as a source 
of foreign exchange or a credit ( + ) at 1.3. Part (b) is clearly an in- 
crease in U.S. assets abroad, as U.S. direct foreign investment is in- 
creased. This is a use of foreign exchange, a debit ( — ), recorded at 
III.l. 

15. (a) A U.S. corporation's affiliate, incorporated in a foreign coun- 
try, earns $165 and (b) decides to leave the earned income to be re- 
invested in the subsidiary abroad. 

This type of transaction was recorded in the U.S. balance of pay- 
ments for the first time in June 1978. In the past, retained earnings 
transactions (nonrepatriated income) between the parent corporation 
and its affiliate, incorporated in a foreign country, had arbitrarily been 
excluded from balance-of-payments transactions. Perhaps this was due 
to the difficulty of obtaining the data, together with the fact that the 
volume was small. In recent years, however, the volume has increased 
significantly. Also, this change in the U.S. balance-of-payment record- 
ing brings U.S. practice in line with IMF standard accounting pro- 

8 Any capital outflow from a parent to its subsidiary abroad is recorded as 
direct foreign investment for balance-of-payments purposes. The maturity of 
the loan is irrelevant. This is done partly because in some cases it is difficult 
to segregate such capital flows by maturity, partly because in some foreign 
countries there are restrictions on repatriation of income on investment but not 
on loans. Thus, many multinational corporations supply funds to their sub- 
sidiaries in the form of loans with different maturities, rather than in equity 
form. 

7 Branches are defined as unincorporated affiliates which have no legal identity 
apart from the parent firm. Subsidiaries are incorporated affiliates. 



Recording and Classifying Balance-of-Payments Transactions 119 



cedure. Part (a) of this transaction is recorded as a credit ( + ) at 1.3 
in exhibit 1 because earned receipts on past investments are arbitrarily 
classified as a credit ( + ) . Part (b) is recorded as a debit ( — ) at III.l 
because reinvested earnings are a direct investment, and an increase in 
U.S. investment represents an increase in U.S. assets, a use of foreign 
exchange, and hence a debit ( — ) . Exhibit 2, the most current balance- 
of-payments format (since 1978), contains specific categories to enter 
this transaction. Accordingly, the credit is recorded in line 13 whereas 
the debit is recorded in line 50. If the firm were a foreign incorporated 
affiliate in the U.S., the balance-of-payments entries in exhibit 1 
would be inverted from those stated above. In exhibit 2, the debit 
would be in line 29 and the credit in line 67. 

Banks and Other Financial Institutions 

16. (a) A U.S. bank sells $115 worth of U.S. treasury bills to a French 
investor, (b) who pays with his dollar deposits at another U.S. bank. 

Part (a) represents an increase in U.S. government short-term lia- 
bilities to foreigners and is thus a source of foreign exchange and a 
credit ( + ) ; (b) is a debit ( — ), a decline in U.S. bank deposit liabili- 
ties to foreigners. Part (a) is recorded at IV. 2 since it represents a 
short-term claim of a private foreigner. Even though the treasury bills 
are a liability of the United States Treasury, the holder of the claim is 
a private foreigner, and since the recording is performed, with very 
few exceptions, on the basis of who owns the claim, it is recorded at 
IV.2. Part (b) is recorded in IV.2 since it represents a decline in lia- 
bilities to private foreigners. 

17. (a) A U.S. bank sells $155 worth of U.S. treasury long-term bonds 
to an investor in Spain, (b) The Spanish investor pays by drawing on 
his dollar deposits at the same U.S. bank. 

Part (a) of this transaction is an increase in U.S. government long- 
term liabilities to foreigners and as such, it is a source, a credit ( + ), 
recorded at III. 3. Part (b), a reduction in liquid liabilities to private 
foreigners, is a use, a debit ( — ) , recorded at IV.2. 

18. (a) A Netherlands commercial bank transfers $30 of its dollar de- 
posit in a U.S. bank to (b), a guilder deposit in the Netherlands central 
bank. 

Part (a) is a decline in U.S. deposit liabilities to private foreigners 
and thus a use ( — ), entered in exhibit 1 at IV.2. Part (b) depends on 
what the Netherlands central bank does with the dollar check drawn 
on a U.S. bank. If it deposits the check in the United States, the result 



120 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



would be an increase in a U.S. liability to a foreign official institution; 
thus it is a source ( + ) and entered at VI. 1, as has in fact been re- 
corded. Alternatively, the Netherlands central bank could have used 
the check to buy guilders from the New York Federal Reserve Bank; 
in that case, there would be a decrease in U.S. assets, also a credit and 
a source of foreign exchange but one that would be recorded at VI.4. 

19. (a) A U.S. bank accepts a $330 draft from a French importer 
denominated in Deutschemarks. (b) The French importer discounts the 
$330 acceptance 8 with the same U.S. bank receiving dollar deposits 
for this amount. 

Part (a) is an increase in short-term claims of a U.S. resident. This 
is a use of foreign exchange, a debit ( — ), recorded at IV. 1. Part (b) 
is an increase in short-term liabilities to foreigners, a source of foreign 
exchange, a credit ( + ) ; it is recorded at IV.2. This type of transaction 
would most likely enter the balance of payments slightly changed be- 
cause the party discounting the acceptance at the bank would receive 
a sum less than the face value of the acceptance. Therefore, part (b) 
of the transaction, the discounting of the acceptance, will create a 
short-term liability (the credit) of say $320 rather than the full $330. 
That means that part (a) of the transaction, the bank's claim against 
nonresidents (the debit), is $330, but the liability (the credit) is $320. 
When the bank sends its monthly report to the United States Treasury, 
which includes only assets and liabilities vis-a-vis nonresidents, it will 
show debits greater than credits by $10. In that case, for balance-of- 
payments recording purposes, errors and omissions must be credited 
in the amount of $10. 

20. (a) A U.S. bank purchases $95 worth of commercial paper denomi- 
nated in Canadian dollars from a Canadian corporation, (b) It pays 
for the commercial paper by crediting the deposit account that the 
Canadian corporation maintains at a bank in the United States. 

Part (a) is an increase in U.S. short-term financial assets (claims), 
a use of foreign exchange, a debit ( — ), recorded at IV. 1. Part (b) is 
an increase in U.S. liabilities to private foreigners, a source, a credit 
( + ), recorded at IV.2. 

8 An acceptance, also a banker's acceptance, is a letter of credit, an export 
draft, trade bill, or any other instrument of trade financing signed by a leading 
bank, thus becoming a negotiable instrument. For a detailed description of the 
various import and/or export financing instruments see: Morgan Guaranty 
Trust Company, The Financing of Exports and Imports (1977); H. E. Evitt, 
A Manual of Foreign Exchange (London: Pitman, 1971); and D. P. Whiting, 
Finance of Foreign Trade (London: McDonald & Evans, 1973). 



Recording and Classifying Balance-of-Payments Transactions 121 



21. (a) A U.S. commercial bank lends $550 for a three-year term to 
the government of Argentina. The proceeds of the loan are used to 
pay for oil imports from oil companies owned by the government of 
Venezuela, (b) The Venezuelan government decides to keep the dol- 
lars received as part of its official reserves in the form of dollar de- 
posits at a bank in the United States. 

The loan made by the U.S. bank, part (a), represents an increase in 
U.S. long-term financial claims (assets) against the government of 
Argentina. It is a use of funds, a debit (— ), and since it is a claim 
of a private institution in the United States, it is recorded at III. 2. 
Part (b) results in an increase in U.S. liabilities to foreign official 
agencies, that is, the central bank of Venezuela. The increase in lia- 
bilities is a source, a credit ( + ) , and since a foreign official institution 
owns the claim, it is recorded at VI. 1. 

Central Banks and Other Institutions 

22. (a) The Italian government sells a $470 issue of long-term govern- 
ment bonds, denominated in dollars, to U.S. investors, and (b) keeps 
the dollar proceeds in its official exchange reserves in the form of de- 
posits at U.S. commercial banks. 

Part (a) is an increase in U.S. holdings of financial assets, and it is 
therefore entered as a use ( — ) of foreign exchange at III. 2 in exhibit 
1. The bonds are issued by a government, not a private corporation. 
The claim, however, is held by private U.S. investors. In the balance- 
of-payments accounts, the structural classification of a transaction al- 
ways denotes who owns the claim rather than who issued it. Part (b), 
an increase in U.S. deposit liabilities owed to a government rather than 
a private individual or firm, is entered as a credit ( + ) or source of 
foreign exchange in exhibit 1, at VI. 1. The entry is at VI. 1 rather than 
IV.2 because it is a foreign government claim rather than a foreign 
private claim against the United States. For balanoe-of-payments ac- 
counting purposes, it makes no difference if the foreign government 
deposits are kept at the Federal Reserve Bank of New York or at a 
private commercial bank in the United States. In practice, deposits 
of foreign governments are kept at both the Federal Reserve Bank of 
New York and at U.S. commercial banks. In either case, they are con- 
sidered official deposits. 

23. (a) The Federal Reserve buys $40 worth of British pounds (b) 
with Swiss francs in an effort to bolster the pound. 

Part (a) is an increase in official U.S. holdings of pounds (assets) 



122 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



and hence a use of foreign exchange and a debit ( — ). Part (b) is a 
decrease in official U.S. holdings of Swiss francs (assets) and thus a 
source of foreign exchange, a credit ( + ) . Both parts of this transaction 
are entered in exhibit 1 at VI.4. 

24. (a) The central bank of France purchases $280 worth of gold, this 
time from the United States Treasury, and (b) pays by again drawing 
its official deposits at a bank in the United States. 

Part (a) is a reduction in official U.S. reserve assets (gold) and thus 
a source ( + ) of foreign exchange, while (b) is a reduction in U.S. 
liabilities to France and therefore a use ( — ) . Part (a) is entered in 
exhibit 1 atVI.2, (b) atVI.l. 

25. (a) Mexico's central bank sells $100 worth of IMF Special Draw- 
ing Rights to the Federal Reserve Bank of New York, (b) The Federal 
Reserve pays for the SDRs by increasing Mexico's dollar deposit at 
the Federal Reserve Bank of New York. 

Part (a) increases official U.S. reserve assets, which by Rule 2 is a 
use or a debit ( — ); (b) is an increase in official U.S. liabilities, a 
source or a credit ( + ). Part (a) is entered at VI. 3, and (b) at VI. 1. 

26. (a) The United States acquires $220 of SDRs (b) as the IMF 
allocates that amount of SDRs to the United States. 

Part (a) is an increase in official U.S. reserve assets and, based on 
Rule 2, a use of foreign exchange or a debit ( — ) ; it is entered in ex- 
hibit 1 at VI. 3. But what happens to the contra, the corresponding 
balancing entry? It must be a source of foreign exchange or a credit 
( + ) , but Rule 1 is not applicable since there is neither a decrease in 
U.S. assets nor an increase in U.S. liabilities. It is obvious, nevertheless, 
that the receipt of SDRs is in itself a source of foreign exchange. 
Arbitrarily, then, whenever there is an allocation of SDRs by the IMF, 
it is entered as a source of foreign exchange in the miscellaneous capital 
account at V.l. 

27. (a) The United States Treasury buys $25 worth of newly mined 
gold from the South African government and (b) pays for it with dol- 
lars which the South African government chooses to leave in its de- 
posit account at a bank in the United States. 

Part (a), gold acquired for monetary purposes, is an increase in 
official U.S. reserve assets. As such, it is a use of foreign exchange, a 
debit ( — ), recorded at VI. 2. Part (b), however, represents an in- 
crease in official U.S. liabilities to official foreigners, a source ( + ), 
recorded at VI. 1. The purchase of gold could have been made from 



Recording and Classifying Balance-of -Payments Transactions 123 



any other country or official institution, and the nature of the record- 
ing would not have changed unless the payment for the gold were in 
SDRs or other convertible currencies. In that case, the United States 
would have lost assets in the form of SDRs (or convertible currencies) 
and, according to Rule 1, that decrease in assets would have been a 
source of foreign exchange and a credit recorded at VI. 3 (or VI.4). 
What if the gold had been bought from a private mine in Africa? In 
that case, part (a) would still be recorded as a debit at VI. 2, but 
part (b) would be recorded as a credit at IV.2 if the payment were in 
dollars, representing an increase in U.S. dollar liabilities to nonofficial 
foreigners. On the other hand, if the payment were made in foreign 
currency held by the United States Treasury, part (b) would be re- 
corded as a credit at VI.4. 

28. (a) The United States Treasury buys $210 worth of newly mined 
gold from a mining company in the United States, (b) ? . . . 

Part (a), given the nature of gold, is an increase in the official 
reserve asset holdings of the United States. As such, it is recorded as a 
use of foreign exchange and entered in exhibit 1 as a debit ( — ) at 
VI. 2. Part (b), however, cannot be analyzed in orthodox terms, since 
no transaction has occurred between residents of the United States and 
residents of the rest of the world. Arbitrarily, therefore, to balance the 
accounts, a credit ( + ) is posted as a source of funds in the merchan- 
dise export account, at 1.1, even though no export has actually taken 
place. 9 

29. (a) The U.S. government ships $110 of wheat to India (b) as a 
gift. 

Part (a) is an export, reducing U.S. assets, and is thus a source ( + ) 
of foreign exchange recorded in exhibit 1 at 1.1. Part (b), however, 
again fits neither rule: it does not represent an increase or a decrease 
in either assets or liabilities. Arbitrarily, unilateral transfers, such as 
gifts and donations, are recorded as uses ( — ) ; in this case, it is entered 
in exhibit 1 at II. 2. (Again, one could "force" unilateral gifts into 
Rule 2 by reasoning that they buy an intangible asset such as goodwill.) 

30. From a stock purchase in a U.S. corporation undertaken several 
years earlier which represented 15 percent ownership in that corpora- 
tion, (a) an Arabian government receives $310 in dividend income 
(b) which is reinvested by the Arabian country in the same corpora- 
tion. 



9 For a logical explanation of this entry, see John P. Powelson, Economic Ac- 
counting (New York: McGraw-Hill, 1955), pp. 390-91. 



124 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Part (a), the actual payment of dividends by the United States to a 
foreign country, again does not represent an increase or a decrease in 
either assets or liabilities. Arbitrarily, the payment of dividends from 
the United States to foreigners is recorded as a use of foreign exchange, 
a debit ( — ), at 1.3. Part (b) reduces U.S. assets vis-a-vis foreigners 
and represents a source of foreign exchange, a credit ( + ) , and is re- 
corded at III. 1 . Official foreign government reinvested earnings have 
always been treated as the reinvested earnings of a nonincorporated 
branch. See transactions 14 and 15. 

Eurocurrency and Other Inter-Bank Transactions 

31. (a) An American corporation transfers $65 from a bank in the 
United States to a Eurodollar bank in London. 10 (b) The Eurodollar 
bank in London maintains deposit balances at another bank in the 
United States and chooses to add this $65 to its deposits in that U.S. 
bank. 

Part (a) is an increase in an American corporation's claims (finan- 
cial assets) on a foreign bank. More specifically, it represents a non- 
bank liquid claim on foreigners. This is a use of foreign exchange, a 
debit ( — ), recorded at IV. 1. The fact that the financial asset is de- 
nominated in dollars is irrelevant; it is a U.S. -owned claim on a foreign 
bank, and whether that bank records the claim in pounds or dollars 
makes no difference. In part (b), a London bank increases its claims 
on a U.S. bank. From the U.S. balance-of-payments point of view, 
U.S. liquid liabilities to foreigners increase. This is a source, a credit 
( + ), recorded at IV.2. Another possible outcome is that the London 
bank, or someone else who receives the check in due course, uses the 
check to buy pounds and buys them from a U.S. bank. Here the United 
States loses assets in the form of foreign currency; this is also a source 
but one that would be recorded at IV. 1. Still another possibility is that 
the London bank exchanges the dollar check for pounds at the Bank 
of England. The Bank of England in turn uses the dollar-dominated 
check to increase its official deposits at the Federal Reserve Bank of 
New York. In this case, U.S. liabilities to a foreign official institution 
will increase; this is also a source and would be recorded at VI. 1. 

32. (a) A U.S. commercial bank borrows $85 for three months from 
its London branch, (b) The London branch maintains dollar deposits 
at the U.S. parent bank as reserves for its Eurodollar deposit liabilities. 

10 Eurodollar banks are those banks outside the U.S. territory that accept dollar 
deposits and make loans denominated in dollars. 



Recording and Classifying Balance-of -Payments Transactions 125 



The borrowing by the U.S. parent bank results in an increase in li- 
quid liabilities to its foreign branch. This is a source, a credit ( + ) , re- 
corded at IV.2. When the London branch lends dollars to the U.S. 
parent, it loses an equal amount of the dollar reserves it had as deposits 
at the U.S. parent bank. To the parent bank in the United States, this 
is a decline in its (deposit) liabilities to the foreign branch and a use 
of foreign exchange, a debit ( — ), which is also recorded at IV.2. 
(See Appendix B.) 

33. (a) An American investor sells some land it owns in Peru to a 
Japanese firm for $200. (b) The Japanese firm pays the U.S. investor 
with a check drawn on its dollar deposits held at a Eurodollar bank in 
Zurich. 

Part (a) is a decrease in U.S. holdings of real fixed assets abroad. 
This is a source, a credit ( + ), and is recorded as direct foreign in- 
vestment at III. 1. Part (b) is a decline in short-term liquid liabilities 
to private foreigners. It is a use of foreign exchange, a debit ( — ), 
recorded at IV.2. This is because it is assumed that all Eurodollar 
banks maintain dollar deposits in U.S. banks as reserve against their 
dollar deposit liabilities. When a depositor at the Eurodollar bank 
writes a check on that account in payment to a party who does not keep 
an account in the same Eurodollar bank, then the Eurodollar bank in 
turn loses dollar deposits in the United States (reserve dollar deposits). 
In fact, Eurodollar banks maintain very small dollar deposits (relative 
to their dollar liabilities) in U.S. banks. They hold instead dollar or 
other hard-currency donominated assets which they can convert into 
dollar deposits if a dollar claim is presented to them for payment. In 
any case, the final debit ( — ) in the balance of payments will most 
likely be recorded in short-term liquid capital as a decrease in liabili- 
ties to foreigners. 

34. (a) A U.S. corporation borrows $540 from the London branch of 
a U.S. bank, (b) The U.S. corporation uses the funds to pay for pur- 
chases from another U.S. firm, which in turn deposits the dollars at 
another U.S. bank. 

When a U.S. corporation borrows from a non-U. S. resident bank, 
U.S. short-term liabilities to foreigners increase. Thus part (a) of the 
transaction is a source, a credit ( + ) , and recorded at IV.2. With re- 
spect to part (b), the London branch which had either owned the 
reserves, perhaps as deposits in its parent U.S. bank or in any other 
U.S. bank (or was forced to acquire them to settie this transaction), 



126 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



will lose an equal amount of reserves. This means the liquid liabilities 
of the parent bank (or any other U.S. bank) to the London branch 
decline. This is a use, a debit ( — ) , recorded at IV.2. 

35. (a) A Eurodollar bank in Germany lends $170 to a German multi- 
national firm (b) that uses the funds to buy Swiss francs at a Swiss 
bank. 

Part (a) will result in a decline of U.S. liabilities to the German 
bank. This is a use of funds, a debit ( — ) , recorded at IV.2. Part (b) 
will result in an increase of U.S. liabilities to the Swiss bank. This is 
a source, a credit ( + ) , also recorded at IV.2. When the net balance for 
the short-term private capital accounts is obtained in exhibit 1, this 
transaction (as well as transactions 7, 16, 19, 20, 31, 32, and 34) will 
cancel out. 

Defense-Related Transactions 

36. (a) The government of Israel purchases $290 worth of military 
equipment from a private manufacturer in the United States, (b) pay- 
ing by check drawn on its dollar deposits at a bank in the United States. 

Part (a) is an export of goods, a decrease in assets, and therefore 
a source ( + ) of foreign exchange, entered at LI. Part (b) is a de- 
crease in U.S. liabilities, hence a use ( — ) , entered at VI. 1. 

37. (a) The government of Iran purchases $270 worth of military 
equipment from the United States Defense Department, (b) It pays by 
drawing on its dollar deposits at the Federal Reserve Bank of New 
York. 

Part (a) is an export of goods, a decrease in real assets, and hence 
a source ( + ) of foreign exchange and a credit. It is entered at 1.5. 
Part (b) represents a decline in official U.S. short-term liabilities to 
foreigners, a use ( — ), entered at VI. 1. Note that this and transaction 
36 are almost identical except that the purchase in 36 is from a private 
manufacturer, and the credit is recorded as an export. Here the pur- 
chase is from a U.S. government agency, and the credit is entered in 
foreign military spending (military agency sales contract) . 

38. (a) A U.S. military agency purchases $435 in goods and services 
from private firms in Spain, (b) It pays for the goods and services with 
peseta deposits that it held in Spain's central bank. 

The purchase is an increase in U.S. military assets and hence a use 
( — ) of foreign exchange, recorded at 1.5. The payment is a decline in 
official U.S. liquid assets held abroad, a source ( + ) ; it is recorded 



Recording and Classifying Balance-of -Payments Transactions 127 



at VI.4, rather than at IV. 1, because the owner of the financial assets 
is the U.S. government, not a private person or firm. 

39. (a) The United States ships $240 in goods and services to Greece 
(b) under an official military grant program. 

Part (a) of this transaction fits Rule 1 in that it represents a decline 
in U.S. assets, and, hence, it is a source ( + ) of foreign exchange. It is 
recorded as a military grant at 1.6 in exhibit 1. But (b) fits neither 
rule; it represents neither an increase nor a decrease in either assets or 
liabilities. Arbitrarily, military grants of goods and services are con- 
sidered uses ( — ) of foreign exchange and recorded in exhibit 1 at 
1.6. (One could possibly force military grants of goods and services into 
Rule 2 by reasoning that such spending buys an intangible asset, such 
as perimeter defense or goodwill.) 

40. (a) The United States increases Turkey's official dollar holdings 
at the Federal Reserve Bank of New York by $230 (b) in fulfillment of 
a military grant. 

Part (a) fits Rule 1 in that it represents an increase in U.S. liabilities 
to foreign official institutions and is thus a source ( + ) of foreign ex- 
change. It is recorded at VI. 1 in exhibit 1. Part (b), however, fits 
neither rule. Like transaction 39, it is arbitrarily labeled as a use 
( — ) and recorded as a unilateral transfer at II. 2. The only difference 
between part (b) of this transaction and part (b) of transaction 39 
is that 39, a military transfer of goods and services, is entered at 1.6, 
while here, as a military transfer in cash, it is entered under unilateral 
transfer at II.2. 11 

OPEC-Related Transactions 

41. (a) An American multinational corporation engaged in the pro- 
duction, distribution, and marketing of oil pays an Arabian country 
$450 in royalties, (b) The Arabian country chooses to keep the dollars 
as an interest-earning deposit at a bank in New York. 

Part (a), the royalty payment, is neither an increase nor decrease in 
an asset or a liability. It is arbitrarily classified as a use of foreign 
exchange and a debit ( — ), recorded at 1.3. Part (b) is an increase in 
U.S. dollar liabilities; it is hence a source, a credit ( + ), and is re- 
corded at VI. 1 since the claim is held by an official foreign institution. 
These "petrodollars" become a balancing item. It is generally assumed 

11 The category "unilateral transfers" includes all nonmilitary government and 
private gifts, regardless of the form that the gift takes. It also includes those 
military grants for which a cash disbursement is made. 



128 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



that balancing items transactions are undertaken to influence the for- 
eign-exchange market. In fact, traditionally, the volume of transactions 
in balancing items measured the degree of intervention by central 
banks and official institutions in foreign-exchange markets. This trans- 
action 41 is clearly not for the purpose of affecting the exchange rate 
but rather for the purpose of earning interest. There have always been 
some transacitons of this nature included in the balancing items, but 
their volume was insignificant until OPEC emerged. Since then, the 
balancing items cannot be used without considerable adjustment as an 
indicator of official intervention in foreign-exchange markets. 

42. (a) Japan draws $600 of its official dollar deposits held in the 
United States in order to pay an Arabian country for an oil shipment, 
(b) The Arabian country, the recipient of the dollars, uses the funds 
to purchase stock in a U.S. petroleum corporation. (This investment 
represents 20 percent of the stock of the U.S. firm.) 

Part (a) results in a decline in U.S. liabilities to official foreigners; 
it is a use of foreign exchange, a debit ( — ), recorded at VI. 1. Part 
(b), the Arabian purchase of stock in a U.S. corporation, represents a 
decline in U.S. assets, a source, and a credit ( + ) . Because it is a stock 
purchase and represents more than 10 percent ownership, it is re- 
corded — contrary to all other official international agencies and 
government claims, which are recorded in Part VI under balancing 
items — as a long-term investment at III.l. 

43. (a) An Arab country draws $135 of its official dollar holdings at 
a U.S. bank (b) to pay for the purchase of common stock in a U.S. 
corporation. The total purchase amounts to 5 percent of the outstand- 
ing stock in the corporation. 

Part (a) results in a decline in U.S. liabilities to official foreign 
institutions; it is a use of foreign exchange, a debit (•— ) recorded at 
VI. 1. Part (b), the Arabian purchase of stock, is a decline in U.S. 
assets, a source, and a credit ( 4- ) . Because it is a portfolio investment, 
it is classified at VI. 1 under balancing items. Prior to 1975, this credit 
would have been recorded at III.l, but since then it is assumed that 
stock purchases of less than 10 percent of the total stock outstanding 
are as liquid an investment as the purchase by foreign governments of 
bonds or other debt instruments and are classified under VI. 1. The 
debt instruments purchased by foreign governments have always been 
classified under VI. 1, thus affecting the balancing items category, and 
its meaning, as discussed in 41 above. 



Recording and Classifying Balance-of -Payments Transactions 129 



44. (a) A Kuwaiti sheik buys vacation homes in California for $180. 
(b) He pays in dollars which he withdraws from his dollar deposit at a 
New York commercial bank. 

Part (a), as such, will probably never be recorded in the balance of 
payments, because it is unlikely to be reported to the data collection 
agencies. Instead, the United States Department of Commerce esti- 
mates a quarterly figure for real estate acquired by foreign individuals 
in the United States. If the estimate is correct, it will include this as 
well as many similar transactions. This represents a decline in U.S. 
long-term assets vis-a-vis nonresidents, and, thus, is a source, a credit 
( + ), recorded as direct foreign investment at III.l. Part (b) will most 
likely be reported by the New York bank to the United States Treasury 
as a decline in short-term liabilities to foreigners. As such it is a use, 
a debit ( — ) , recorded at IV.2. 

CONCLUDING COMMENTS 

The balance of payments is nothing more than a national statement 
of sources and uses of foreign exchange, comparable to a corporate 
statement of sources and uses of funds. Each international transaction 
requires two entries due to the nature of double-entry bookkeeping, and 
despite the growing complexity of international transactions, the ap- 
propriate entries for the most part follow the same principles (rules) 
that apply to the construction of any standard sources-and-uses-of-funds 
statement. Four types of transactions, however, require special arbi- 
trary rules: unilateral transfers, allocations of SDRs by the IMF, 
interest and dividends, and domestically mined gold purchased by the 
Treasury Department. Discussion and enumeration of examples of 
these types of transactions appear in transaction 9. 

Based on the grounding of exhibit 1, one can more fully appreciate 
and analyze the implications of the more commonly used and more 
complex balance-of-payments presentations, such as that in exhibit 2, 
which is published quarterly in the Survey of Current Business. 

Finally, a word is in order with respect to the collection of balance- 
of-payments data. The transactions presented in this paper are realistic. 
They do take place in the manner described. However, the United 
States Treasury and the federal reserve banks on behalf of the Trea- 
sury, together with the Balance of Payments Division of the Depart- 
ment of Commerce — the organizations responsible for the compila- 
tion, classification, and presentation of the data — cannot obtain the 
data for each individual transaction that takes place during a given 



130 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



period. Therefore, the data that is eventually published in the U.S. 
balance of payments is obtained from various sources. 12 

For example, data on merchandise exports and imports are obtained 
largely from monthly Census Bureau figures which are basically col- 
lected for customs purposes and which may therefore differ substan- 
tially in valuation, coverage, and timing from the figures that would 
ideally be best suited for balance-of-payments purposes. Adjustments 
are made where possible to value exports as free alongside ship 
(f.a.s.) in the United States and imports as f.a.s. in foreign ports. Tour- 
ist expenditures and related figures are obtained from the United 
States Immigration and Naturalization Service. These figures are in 
fact estimates based on number of passengers, airfare costs, and average 
expenditures by tourists. Other data come from relevant government 
and international agencies and from regular reports filed by financial 
institutions and multinational firms. 

Under the circumstances, total debits and credits rarely match. For 
instance, it is unlikely that the total figure for merchandise imports 
(debits) for any one period, obtained from Census data, will be 
exactly offset by the means of payments (credits) reported by financial 
institutions. For this and other reasons, the need thus arises for a 
balancing entry under the heading "errors and omissions" (V.2 in 
exhibit 1 ) . In recent years, this figure has averaged $6 billion annually, 
which is approximately 4 percent of total exports, approximately 50 
percent of the merchandise trade balance, and from 50 to 100 percent 
of the official reserve transactions balance. 



lJ For the most up-to-date information pertaining to the type and source of 
data included in the balance of payments, see the Survey of Current Business 
(June 1978), part II. For earlier versions of similar information, see The Bal- 
ance of Payments of the U.S., 1949-51, Supplement to the Survey of Current 
Business (1952) ; also the Review Committee for Balance of Payments Statistics, 
The Balance of Payments Statistics of the United States: A Review and Ap- 
praisal (Washington, D.C.: United States Government Printing Office, 1965), 
also known as the Bernstein Report; and "The U.S. Balance of Payments: 
Revised Presentation," Survey of Current Business (June 1971). 



Recording and Classifying Balance-of-Payments Transactions 131 



APPENDIX A. 



Tracing the intermediate steps before the ultimate form that part (b) of 
this transaction assumes in the U.S. balance of payments will clarify some of 
the mechanics of short-term capital movements between the United States 
and the rest of the world that are relevant in this instance and for several 
other transactions that follow. When the U.S. corporation makes the loan 
to its subsidiary, it gives up cash or demand deposits in its checking account 
at a bank in the United States. The transaction can be recorded in the form 
of "T account" (where pluses and minuses represent increases and decreases, 
respectively, in assets and/or liabilities) as follows: 

U.S. Parent Corporation 



Cash or 




deposit 


-150 


Loan 


+ 150 



The foreign subsidiary of this corporation, upon receiving the dollar loan, 
will have an increase in dollar holdings as well as an increase in loans pay- 
able. Subsequently, it will use the holdings to pay for merchandise acquired 
from a local French supplier. These transactions can be summarized as 
follows: 

Foreign Subsidiary 



Dollar holdings +150 



Dollar holdings 
Inventory 



-150 
+ 150 



Loans payable +150 



The French supplier, after reducing its inventory by the amount sold to 
the U.S. subsidiary and obtaining dollars in payment, proceeds to deposit the 
dollars in a Eurodollar bank, which in this case is a branch of a U.S. bank. 
The accounts of the French supplier: 

French Supplier 



Inventory 
Dollar holdings 



-150 
+ 150 



Dollar holdings —150 

Eurodollar deposit +150 



The Eurodollar bank in France — the U.S. bank's branch in France, 
which is considered a foreign bank for U.S. balance-of-payments purposes 
— will receive the Eurodollar deposit from the French supplier, and when 
these dollars clear, the Eurodollar bank acquires dollar deposits in a U.S. 
bank, in this case most likely its parent bank. Banks usually call the amounts 
they hold for their own foreign branches "credit balances" rather than "de- 



132 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



mand deposits." Thus, the Eurodollar bank in France and the U.S. bank's 
accounts will be as follows: 



Eurodollar Bank in France 
(A U.S. Branch) 



Parent U.S. Bank 



Credit balance 


Eurodollar de- 


due from 


posit due 


parent or 


French supplier 


home office 


+ 150 


+ 150 





Dollar deposit 
due to X 
owner, perhaps 
the U.S. par- 
ent corporation 

Dollar credit bal- 
ance due to 
own foreign 
branch + 150 
-150 



Finally, the balance-of-payments accounts that follow show the only two 
transactions that ultimately reflect changes in assets and liabilities of U.S. 
residents vis-a-vis residents of the rest of the world. Namely, the increase in 
long-term fixed assets or direct foreign investment that emerges from the 
loan by the parent corporation to the subsidiary in France, and the increase 
in dollar liabilities to a Eurodollar bank that emerges when the Eurodollar 
bank acquires dollar deposits: 

U.S. Balance of Payments 



Direct foreign 
investment 



+ 150 



Liquid liabilities 
to foreigners 



+ 150 



If the U.S. corporation borrowed dollars from its subsidiary abroad, the 
same accounts in the balance of payments as in transaction 46 would be 
affected, but the debit would be a credit and vice versa. 



Recording and Classifying Balance-of -Payments Transactions 133 



APPENDIX B. 



Before transaction 32 takes place, it can be assumed that the London 
branch has a $100 deposit at the U.S. parent bank and that therefore the 
U.S. parent bank has a $100 liability due to its London branch. This situation 
is illustrated above the dotted line in the "T accounts" that follow: 

U.S. Parent Bank London Branch Bank 



Credit balance in dollars Credit balance due from 
due to London U.S. parent + 100 

branch +100 



Three months' borrow- Three months' dollar 
ing from London loan to parent +85 

branch + 85 

Credit balance due to Credit balance due from 

London branch —85 U.S. parent —85 

When transaction 32 occurs, the borrowing U.S. parent bank acquires a 
three-month $85 liability due to its London branch. The London branch 
acquires an $85 asset in the form of a three-month loan. Since the London 
branch uses part of its credit balance at its parent bank to make the loan, 
the branch loses $85 of that credit balance and concurrently the parent bank 
credit balance due to its branch is reduced by an equal amount. Therefore, 
the London branch account will show both the decline in its credit balance 
at its parent bank and an increase in the three-month loan due from the 
parent bank. The parent bank's account, on the other hand, will show an 
increase in a three-month loan liability to the branch and a reduction in its 
credit balances due to its London branch. These transactions are recorded 
below the dotted line in the "T accounts" above. 



A Study of International Accounting Education 
in the United States 

JANE O. BURNS* 



An increasing number of U.S. corporations are operating in multiple 
environments. During the last twenty years, annual direct foreign in- 
vestment more than tripled. Currently, approximately 3,500 U.S.-based 
multinational corporations control over 25,000 foreign affiliates. This 
is an increase from 2,500 companies controlling 10,000 corporations 
abroad in the late 1950s. For 200 U.S. companies, income of foreign 
subsidiaries exceeds 25 percent of total income. 1 Exports also are ex- 
periencing dynamic growth. Since the 1950s, total merchandise ex- 
ports have risen sevenfold to $120 billion in 1977. In fact, "[i]t is 
difficult to point to a firm of any size which is not involved in or af- 
fected by some aspects of international business." 2 

University education began to respond to the growing internationali- 

* Jane O. Burns is assistant professor of accounting at the Graduate School of 
Business, Indiana University. 

This study is an extension of the Education Committee, International Ac- 
counting Section of the American Accounting Association. The author wishes 
to express special appreciation to Professor Norlin G. Rueschhoff for his en- 
couragement and guidance in designing the survey instrument used in this 
research. 

1 American Accounting Association, Committee on International Accounting, 
"Report of the Committee on International Accounting," Accounting Review, 
Supplement to vol. 48 ( 1973) : 121. 

* American Assembly of Collegiate Schools of Business, The Internationalization 
of the Business School Curriculum (St. Louis, Mo.: American Assembly of Col- 
legiate Schools of Business, 1979), p. 1. 



136 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



zation of business in the late 1950s. 3 In 1974, the American Assembly 
of Collegiate Schools of Business (AACSB) expanded accreditation 
standards to include an international perspective. With the establish- 
ment of a grant from the General Electric Company in 1977, the 
AACSB began conducting a series of regional workshops 

... to assist business schools in following various strategies toward the in- 
ternationalization of the curriculum, which is needed not simply to comply 
with the AACSB standards, but also to prepare their graduates for the busi- 
ness world they will enter. 4 

Two different approaches to internationalizing the business curriculum 
have developed. One approach is to treat international business as a 
single discipline, requiring the establishment of separate multidisci- 
plinary courses. A second outlook broadens existing academic areas 
so that discussions of domestic topics are expanded to include inter- 
national aspects. 

International business studies and more specialized international fi- 
nance subjects commonly include accounting topics. However, con- 
siderable support exists for expanding the coverage of international 
accounting material. 5 At the 1978 AACSB Internationalizing the 
Accounting Curriculum sessions, "[i]t was the consensus of the par- 
ticipants that an international accounting course would have a rela- 
tively high priority in today's accounting environment." 6 In conclu- 
sion, the group stated that international accounting instruction should 
be required at the doctoral level for all accounting majors. 7 Two 
American Accounting Association (AAA) Committee Reports indicate 
separate courses in international taxation also may be useful. 8 

Two surveys of international business courses 9 revealed that many 
more schools offered separate courses in international finance, inter- 

* Schuyler F. Otteson, ed., Internationalizing the Traditional Business Curricu- 
lum, International Business Research Series Number 1 (Bloomington, Ind.: 
Bureau of Business Research, Graduate School of Business, Indiana University, 
1968), p. 4. 

4 AACSB, Internationalization, p. i. 

5 Ibid., p. 24; James D. Goodnow, "International Business in the MBA and 
BBA Core Program," Journal of International Business Studies (Fall 1973) : 81; 
and Gerhard G. Mueller and Vernon Zimmerman, "Internationalization of the 
Accounting Curriculum," in Otteson, Business Curriculum, pp. 53-56. 

8 AACSB, Internationalization, pp. 24-25. 
' Ibid., p. 26. 

* American Accounting Association, Committee on International Accounting, 
"Report" (1973), p. 166; and American Accounting Association, Committee 
on International Accounting, "Report of the Committee on International Ac- 
counting," Accounting Review, Supplement to vol. 49 (1974) : 268. 

9 Vern Terpstra, University Education for International Business (Benton Har- 



U.S. International Accounting Education 137 



national marketing, and international management than they did in 
international accounting (see exhibit 1). Further, many schools had 
more than one course in each of the disciplines except accounting. No 
school provided students with more than one international accounting 
course. 





Exhibit 1. Surveys of International Business Courses 




Study 


Total International International International 
schools finance marketing management 


International 
accounting 


1969 a 
1974 b 


95 40 50 65 
272 133 182 121 


17 
35 



a The 1969 study includes U.S. schools only (Terpstra, University Education, pp. 188-89). 
b The 1974 study includes both U.S. and non-U.S. schools (Daniels and Radebaugh, Curricu- 
lum Survey, pp. 154-66). 



While the ideal may be to integrate international accounting con- 
cepts into existing accounting courses, numerous constraints prevent 
this approach. First, few faculty members are prepared to discuss in- 
ternational aspects of financial, managerial, auditing, information 
systems, or tax accounting. Second, current textbooks rarely include 
such information except for the occasional text with a separate chapter 
on international aspects of accounting. Third, supplementary readings 
are inadequate for many topical areas. 

Since it may be unrealistic to expect existing courses to incorporate 
many international accounting aspects, some schools are turning to a 
separate international accounting course. Typically, the course at- 
tracts a small percentage of eligible students and may be considered a 
burden by some understaffed accounting departments. International 
accounting generally is taught by an enthusiastic individual whose 
preparation time far exceeds that required for most other subjects. As 
a result, exchange of ideas and syllabi in international accounting be- 
comes considerably more important than for other areas. To facilitate 
such exchanges, the Education Committee of the International Ac- 
counting Section of the AAA annually gathers syllabi from its mem- 
bers for distribution through the AAA Syllabus Exchange and for pub- 
lication in Accounting Trends. 10 This study is in response to needs ex- 

bor, Mich.: Association for Education in International Business, 1969); and 

John D. Daniels and Lee H. Radebaugh, International Business Curriculum 

Survey (Academy of International Business, 1974). 

"Thomas J. Burns, ed., Accounting Trends XII (New York: McGraw-Hill, 

1978). 



138 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



pressed by faculty members teaching international accounting and by 
those whose schools desire to offer such a course. 

To obtain information about existing and anticipated international 
accounting courses, a questionnaire was mailed to academic members 
of the International Accounting Section of the AAA (Group I) and 
to departmental chairpersons of all other AACSB schools with ten or 
more professorial-rank faculty members (Group II). There were 62 
schools in Group I and 89 in Group II for a total of 151 schools. 

Replies were received from 117 (77.5 percent) of those contacted 
(see exhibit 2). Thirty-six of the 117 schools have one international 

Exhibit 2. Responses to the Questionnaire 



Does your school have one or more 
international accounting courses? 


Number 
of schools 


Percentage 


of schools 


Yes 

No, but expect to add one in 
next three years 

No and do not expect to add 
one in next three years 


37 

24 

56 

U7 

34 

To! 


24.5 
15.9 
37.1 


31.6 
20.5 

47.9 


Subtotal 


77.5 
22.5 


100.0 


No response 




Total 


100.0 











accounting course, and 1 has three. Twenty-four respondents expect 
to add international accounting to their curriculum within the next 
three years. This will be a first course in international accounting 
for 23 schools and a second course for 1 school. Four respondents 
wrote that they would like to add the subject to their curriculum but 
do not have international accounting faculty resources to do so. Addi- 
tionally, 2 schools with a course and 6 expecting to add one within 
the next three years do not list any faculty members with an interest 
in teaching international accounting. Although Fantl also notes that 
some schools have difficulty obtaining faculty to teach international 
accounting, 11 the problem apparently is one of logistics rather than 
availability. Of the 117 responding schools, 72 list 109 faculty members 

u Irving L. Fantl, "International Accounting: A Curricular Challenge," Col- 
legiate News and Views (Winter 1971) : 16. 



U.S. International Accounting Education 139 



with an interest in teaching international accounting. Twenty of the 
72 do not expect to offer a course in international accounting. 

INTERNATIONAL ACCOUNTING TOPICS 

To obtain information on what international accounting topics should 
be included in the curriculum, three studies sought opinions of business- 
men. 

Tarleton's questionnaire listed thirty topics. 12 Only two were ac- 
counting subjects. Based on mean values derived from a scale of one 
to five, international financial reporting ranked fourth and had the 
smallest standard deviation. International accounting practices ranked 
eighth and had the fifth smallest standard deviation. Although not 
among the thirty topics, international taxation was added to the list by 
several participants. 

Respondents to Patrick's questionnaire ranked accounting as the 
third most important international business subject on a list of five. 13 
Accounting ranked after finance and economics but before marketing 
and management. Respondents rated international taxation as the 
most important international business topic. Two other areas listed 
as very important were accounting problems in foreign operations and 
international cash management. 

Clay's study, an unstructured survey of potential employers, sought 
information on what should be included in an international accounting 
course. 14 He determined the four most important international ac- 
counting subjects to be conceptual differences in international practice, 
currency translation, taxation, and consolidations. Respondents thought 
the course should include information about social, political, and eco- 
nomic factors affecting international business. 

Several authors discuss topics that should be included in an inter- 
national accounting course. Suggestions by Seidler include comparisons 
of accounting principles, taxation, inflation accounting, financial re- 
porting, and differing objectives of accounting. 15 Brummet lists infor- 
mation systems, social and human resource accounting, governmental 

u Jesse S. Tarleton, "Recommended Courses in International Business for Grad- 
uate Business Students," Journal of Business (October 1977) : 438-47. 
u Thomas Patrick, "Attitudes of Alumni and Corporations toward International 
Business Education," Journal of International Business Studies (Spring/Sum- 
mer 1978): 109-11. 

"Alvin A. Clay, "Undergraduate International Accounting Education," Inter- 
national Journal of Accounting (Fall 1975) : 187-92. 

"Lee J. Seidler, "International Accounting — The Ultimate Theory Course," 
Accounting Review (October 1967): 775-79. 



140 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



accounting, budgeting, national income and product accounts, input- 
output analysis, and comparative accounting practices. 16 Topics im- 
portant to Mueller include differences in accounting concepts, cur- 
rency translation, consolidations, international accounting and auditing 
standards, financial reporting, inflation accounting, and the relation- 
ship between accounting and economic development of countries. 17 

While all of the foregoing articles recommend possible subjects to be 
included in an international accounting course, none furnishes a com- 
plete list or indicates how time should be allocated among the topics. 

In this study, respondents were asked to estimate the percentage of 
all assignment time devoted to sixteen specific topics plus any addi- 
tional topics not listed (see exhibit 3). Ranked in mean order, re- 
spondents report they allocate a majority of their time to (1) com- 
parative accounting principles; (2) Financial Accounting Standards 
Board Statement No. 8 and foreign-currency translation; (3) transfer 
pricing, foreign tax credit, and taxation of foreign source income; (4) 
inflation accounting; and (5) financial reporting and disclosure. In 
order of decreasing time allocation, other important topics are (6) cash 
management and foreign-exchange risk management ; ( 7 ) international 
accounting standards; (8) international accounting history and back- 
ground information; (9) nonaccounting business topics, including 
introductory background information; (10) consolidations; (11) other 
topics relating to taxation; (12) other topics relating to management 
accounting; (13) other topics relating to auditing; (14) performance 
evaluation; (15) other topics relating to social accounting; (16) other 
topics relating to financial accounting; and (17) other topics. 

Two of the thirty-nine courses are specialty courses ; one concentrates 
on taxation, the other on international social accounting. When these 
two are omitted from the analysis, the tax-related topic drops from 
third to fifth, and social accounting drops from fifteenth to seventeenth. 

Generally, it is assumed that U.S. multinationals approach interna- 
tional activities from a U.S. perspective rather than from a global one. 
Respondents indicate that U.S. international accounting education 
adopts a similar viewpoint. A majority (54.3 percent) of all classroom 
time is allocated to discussing international topics from the perspective 
of U.S. multinational corporations (see exhibit 4). Study of these 

19 R. Lee Brummet, "Internationalism and the Future of Accounting Educa- 
tion," International Journal of Accounting (Fall 1975): 162-64. 
17 Gerhard G. Mueller, "Whys and Hows of International Accounting," Ac- 
counting Review (April 1965): 392-93. 



U.S. International Accounting Education 141 



Exhibit 3. Allocation of Time (in Percents) to International Accounting by Topic* 

Rank 

by 

mean Topic 

1. Comparative accounting principles 
(D)» 

2. FASB Statement No. 8 and foreign- 
currency translation (F) 

3. Transfer pricing, foreign tax credit, 
and taxation of foreign source in- 
come (K) 

(5)« 

4. Inflation accounting (H) 

5. Financial reporting and disclosure 
(G) 

6. Cash management and foreign-ex- 
change management (C) 

7. International accounting standards 

(I) 

8. International accounting history and 
background information (B) 

9. Nonaccounting business topics, in- 
cluding introductory background in- 
formation (A) 

10. Consolidations (E) 

11. Other topics relating to taxation 
(O) 

12. Other topics relating to manage- 
ment accounting (N) 

13. Other topics relating to auditing 
(L) 

14. Performance evaluation (J) 

15. Other topics relating to social ac- 
counting (P) 

(17)" 

16. Other topics relating to financial 
accounting (M) 

17. Other topics (Q) 

1 Calculations are based on thirty-six completed questionnaires since information was not 
reported for three of the thirty-nine courses. 

b The letter in parentheses following each topic indicates the order in which the topic ap- 
peared on the questionnaire. 

c Calculations are based on thirty-five courses after deleting one international taxation course. 
d Calculations are based on thirty-five courses after deleting one international social account- 
ing course. 



Mean 


Standard 
deviation 


Range 


15.5 


12.4 


0-50 


10.9 


5.9 


0-30 


9.5 
(7.1)° 

7.5 


15.4 
(4.8) c 
5.2 


0-95 

(0-20) c 

0-20 


7.4 


5.0 


0-20 


6.0 


5.2 


0-20 


5.8 


4.6 


0-20 


4.9 


5.3 


0-30 


4.9 
4.8 


5.2 
4.9 


0-20 
0-20 


4.3 


5.6 


0-20 


4.1 


7.6 


0-50 


3.7 
3.6 


4.1 
4.1 


0-20 
0-10 


3.2 
(1.3)i 


11.7 
(2.6)0 


0-70 
(0-10) d 


2.1 
1.8 


3.6 
3.9 


0-10 
0-20 



142 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



topics as they relate to the European Economic Community is a dis- 
tant second (18.6 percent). Other industrial nations are discussed 11.3 
percent of the time. Although emphasized by a few, coverage of non- 
industrial, socialist, and Communist countries is negligible for most 
respondents. 

Exhibit 4. Allocation of Time (in Percent) of International Accounting 
by Economic Category" 



Rank 








by 




Standard 




mean Category 


Mean b 


deviation 


Range 


1. U.S. -based multinational corpora- 








tions (A)° 


54.3 


30.7 


0-100 


2. EEC countries (B) 


18.6 


15.1 


0-50 


3. Industrial nations not included in 








the EEC (C) 


11.3 


14.2 


0-75 


4. Nonindustrial nations (D) 


8.6 


8.8 


0-30 


5. Other (E) 








All multinational corporations 


5.3 


19.6 


0-100 


Socialist and Communist countries 


3.1 


16.7 


0-100 


Miscellaneous 


1.9 


5.4 


0-22 



■ Calculations are based on thirty-six completed questionnaires since information was not 

reported for three of the thirty-nine courses. 

b Some materials overlap; therefore, mean values exceed 100 percent. 

e The letter in parentheses following each category indicates the order in which the category 

appeared on the questionnaire. 



GRADUATE VERSUS UNDERGRADUATE 

Many authors support internationalization of the entire accounting 
curriculum. 18 Since no distinction is made, it appears they believe that 
internationalization should occur at both graduate and undergraduate 
levels. When these authors discuss a separate international accounting 
course, a distinction is made between graduate and undergraduate 
levels. Seemingly in conflict with the argument for including interna- 
tional aspects in existing courses at all levels, many emphasize separate 
courses available solely to graduate students. 19 In contrast, RueschhofT 

"American Accounting Association, "Report" (1973), p. 166; American Ac- 
counting Association, "International Accounting," pp. 276-78; Mueller, "Whys 
and Hows," p. 391; Lee H. Radebaugh, "Internationalizing the Accounting 
and Finance Curricula," in Richard N. Farmer, ed., Multinational Firm Strate- 
gies, vol. 2, (Bloomington, Ind. : Indiana University Division of Research, 
1975), p. 90; and Norlin G. Rueschhoff, "The Undergraduate International 
Accounting Course," Accounting Review (October 1972), pp. 833-36. 
"American Accounting Association, "International Accounting," p. 251; Brum- 



U.S. International Accounting Education 143 



argues that the future of international accounting education is at the 
undergraduate level. 20 The 1977-78 Education Committee, Interna- 
tional Accounting Section of the AAA, recommended (1) that one of 
the first two undergraduate accounting courses should include an in- 
troduction to international accounting, (2) that a separate interna- 
tional accounting course should be offered as an elective to undergrad- 
uates, and (3) that an option to major in international accounting or 
international business should be available to graduate students. 21 

Of the thirty-nine courses included in this study, twenty-six are for 
graduate students, seven are for undergraduate students, and six are 
available to both graduate and undergraduate students. While twenty- 
four schools are in the process of establishing an international account- 
ing course, only eight are sufficiently organized to allow completion of 
the questionnaire. Of these eight courses, six will be offered at the 
graduate level and two at the undergraduate level (see exhibit 5) . 



Exhibit 5. Graduate vs. Undergraduate 



Does your school 
have one or more 
international 
accounting 



Graduate 



Under- 
graduate 



Graduate 
and under- 
graduate 



Total* 



No. Percent No. Percent No. Percent No. Percent 



Yes 



26 



No, but expect 

to add one in 

next three years 6 



66.7 



75 



17.9 



25 



15.4 



39 



100 



100 



The responses include thirty-nine courses offered at thirty-seven schools. 



A majority (70 percent) of the thirty-nine international accounting 
courses have three semester hours credit or the equivalent. Annual class 
enrollments range from seven to ninety students. The mean for all 
courses is twenty-two students. Six of the courses are offered at least 
twice a year, twenty-two once a year, and eleven are offered less often. 
Of the eight proposed courses, two are expected to be offered at least 
twice a year, three once a year, and three will be offered less often (see 

met, "Internationalism," p. 164; Mueller, "Whys and Hows," p. 392; Mueller 
and Zimmerman, "Accounting Curriculum," p. 55; and Radebaugh, "Account- 
ing and Finance Curricula," p. 88. 
30 Rueschhoff, "International Accounting," pp. 833-35. 

American Accounting Association, International Section, Education Commit- 
tee, "The Internationalization of Accounting Curriculum" (1978), p. 2. 



144 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



exhibit 6). A majority (56.4 percent) of the courses are taught in the 
spring term. Although some textbooks are in use, most syllabi contain 
lengthy lists of supplementary readings. 

Exhibit 6. Frequency of Course Offerings 

Does your school 

have one or more 

international Two or more Less than 

accounting times a year Once a year once a year Total* 

courses? No. Percent No. Percent No. Percent No. Percent 

Yes 6 15.4 22 56.4 11 28.2 39 100 

No, but expect 

to add one in 

next three 

years 2 25 3 37.5 3 37.5 8 100 

■ The responses include thirty-nine courses offered at thirty-seven schools. 

CONCLUSIONS 

Compared to most accounting subjects, international accounting is a 
new area. If a faculty decides this material should be included in the 
curriculum, several additional questions must be considered. Should 
international concepts be integrated with existing subjects or should a 
separate course be established? If the decision is to integrate, how will 
this be accomplished? Should each faculty member be responsible for 
the method utilized in each class? Should a committee identify topics 
to be included in each course? Should a committee develop supple- 
mentary reading lists? How can noninternational faculty members 
become informed? 

If a separate course is chosen, different questions must be answered. 
Should it be available to graduate students, undergraduate students, 
or a combination of the two? Should enrollments be limited to students 
who are accounting majors, who have strong accounting backgrounds, 
who have some international background, or to all interested students? 
How often should the course be offered? 

In addition to departmental level questions, each faculty member 
involved must decide on the best approach to the subject, the text and 
supplementary readings, the relevant topics, and how much time should 
be allocated to each topic. Such questions and decisions seem endless. 
But dedicated international accounting faculty members argue for 



U.S. International Accounting Education 145 



internationalizing the curriculum and believe the rewards outweigh 
the difficulties. 

Along with this study, the International Accounting Section of the 
AAA has several working committees to help schools internationalize 
accounting programs. In particular, the 1978-79 Education Committee 
is collecting international accounting syllabi and preparing topical 
reading lists to be used as supplements for financial, managerial, audit- 
ing, information systems, and tax accounting courses. Section commit- 
tees also are concentrating on promoting research in international ac- 
counting, providing communication channels with organizations rele- 
vant to international accounting, establishing continuing education 
programs, and encouraging faculty exchange programs with universities 
abroad. Much remains to be done, but it is an exciting and important 
challenge. 



146 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



INSTRUCTIONS TO AUTHORS 



All manuscripts submitted for consideration should be typed on 8V2 x 11" 
paper and should be double-spaced throughout, including synopsis, footnotes, 
and bibliography. At least two copies should be submitted for review. Margins 
should be appropriately wide to facilitate editing. The title of the paper, the 
author's name, rank, and affiliation, and any acknowledgments should appear 
on the first page of the body of the manuscript. All pages, as well as bibliog- 
raphy, exhibits, and appendices, should be serially numbered. The beginning 
of each paragraph should be indented. Footnotes may be placed either at the 
bottom of the appropriate page, or on a separate page. Each manuscript 
should be accompanied by a brief synopsis of the article explaining its inter- 
national significance. 

HEADINGS 

All major headings within the manuscript should be in capital letters. They 
should not be numbered. Subheadings should be in capital and lower case 
letters on a separate line beginning at the left margin. If third-level headings 
are used, they should begin at the left margin and should end with a period. 
The text will follow on the same line immediately. 

EXHIBITS 

Each exhibit should be tided and numbered. A textual reference should be 
made to each exhibit. It would be helpful if the author would indicate by 
marginal notation where each exhibit should be placed. These instructions will 
be followed as printing practices allow. 

FOOTNOTES 

Footnotes should be numbered consecutively throughout the manuscript with 
superscript arabic numerals. Citations should not be made in brackets in the 
text. Mathematical symbols should not have footnote numbers attached. 
Entries for books should include author's name, title of the work underlined, 
and, in parentheses, place of publication, name of publisher, and date of 
publication. For journals, author's name, title of article within quotation 
marks, title of journal underlined, date of issue in parentheses, and page num- 
bers should be included. Please see the following examples. 

1 William A. Dymsza, Multinational Business Strategy (New York: McGraw- 
Hill, 1972), pp. 49-53. 

2 Geoffrey Holmes, "Replacement Value Accounting," Accountancy (March 
1972): 4-8. 

BIBLIOGRAPHY 

Manuscripts may include a bibliography at the end of the paper. If so, such 
references are not to be limited to those references cited in the text. Each 
entry should contain all data necessary for identification. Citations should be 
arranged in alphabetical order necessary for identification. Multiple works by 



Instructions to Authors 147 



the same author should be listed according to chronological order of publica- 
tion. Examples are listed below. 

Robert L. Aliber and Clyde P. Stickney. "Accounting Measures of Foreign 

Exchange Exposure — The Long and Short of It." Accounting Review, 

January 1975, pp. 44-57. 
American Institute of Certified Public Accountants. Accounting Research 

Bulletin No. 43. New York: AICPA, 1953. 
. "Financial Statements Restated for General Price Level Changes." 

Statement of the Accounting Principles Board No. 3. New York: AICPA, 

1969. 
Leonard Lorensen and Paul Rosenfield. "Management Information and 

Foreign Inflation." Journal of Accountancy, December 1974, pp. 98-102. 
Lawrence Revsine. Replacement Cost Accounting. Englewood Cliffs, N.J.: 



Prentice Hall, 1973. 



MATHEMATICAL NOTATION 



Mathematical notation should be stated as simply as possible so as to simplify 
typesetting. Alignment should clearly indicate superscripts and subscripts. 
Equations which are numbered should have the numbers in parentheses flush 
with the left-hand margin. 



Journal of Business 
Finance and Accounting 

Summer 1979 Volume 6, No. 2 

Editor: J. R. Perrin, University of Warwick, Coventry, U.K. 

Contents 

Operating Decisions and the CAPM M Chapman Findlay III 

Capital Budgeting, Capital Asset Pricing 

and Externalities David J. Fowler and C. Harvey Rorke 

Tax and the Integration of Finance and Investment 

C. P. Rickwood and R. E. V. Groves 

Decomposition Analysis of Financial Statements 

Michael C. Walker, John D. Sfowe and Shane Moriarity 

The Time Series of Earnings for Forecast Reporting 

and Nonreporting Firms William Ruland 

Monitoring Decisions in an Agency Setting 

John C. Fellingham and D. Paul Newman 

An Adaptation of Dicksee's Ship Model Robert Bloom 

On the Inadequacy of a Probabilistic Internal 

Rate of Return Steinar Ekern 

Capital Appraisal and the Case for Average 

Rate of Return: A Comment G. G. Hoskins 

Capital Appraisal and the Case for Average 

Rate of Return: A Reply D. A. Longbottom and L Wiper 

The Quality of Disclosure and the Cost of Capital 

Dan S. Dhaliwal, Barry H. Spicer and Don Vickrey 

Book Reviews 



Annual subscription £14.50 (U.S. $34.00) to library and business subscribers, or £8.25 
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Basil Blackwell, 108 Cowley Road, Oxford, OX4 1JF, U.K. 



THE QUARTERLY REVIEW OF ECONOMICS 
AND BUSINESS 

Vol. 19 Winter 1979 No. 4 

ARTICLES 

Suppliers of Last Resort : The Economics of Self-Supply 

in Common Carrier Industries. . .Robert G. Harris and Robert A. Meyer 
Union Impact on Wages and Fringe Benefits 

of Hospital Nonprofessionals Brian E. Becker 

Utility Equities and the Allocation of Capital 

Resources. George Frankfurter, Ronny Strauss, and Allan Young 

Commercial Bank Capital Debt, Business Risk, 

and Stock Price /. Minor Sachlis and John A. Haslem 

Airline Deregulation : Problems 

and Prospects James P. Rakowski and James C. Johnson 

Early Formulators of Say's Law William O. Thweatt 

NOTE, BOOKS REVIEWED, BOOKS RECEIVED, INDEX VOL. 19 

THE QUARTERLY REVIEW OF ECONOMICS AND BUSINESS is published by the 
Bureau of Economic and Business Research, College of Commerce and Business Administra- 
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INTASI 

International Accounting Studies Institute 
announces publication of the Third Edition of 

A BIBLIOGRAPHY 
OF INTERNATIONAL 
ACCOUNTING 



by Konrad W. Kubin 
and Gerhard G. Mueller 




NTERNATIONAL 

ACCOUNTING 

STUDIES 

INSTITUTE 




First compiled in 1964 and revised in 1968, the bibliography is now 
available in a third edition (published September 1974) representing 
its continued evolution in response to apparent widespread use. During 
the process of selecting references, the authors considered the needs of 
international readers of corporate annual reports and the needs of pro- 
fessional accountants and auditors concerned with international busi- 
ness and finance activities. 

New classifications include: European Economic Community, Foreign 
Currency Translations, International Accounting Education and Re- 
search, and International Historical Aspects of Accounting. Most pre- 
1960 references were eliminated, and references through year-end 1972 
are reasonably complete. All references are in English. 



Price: $5.00 



Order from: BA Faculty Publications, DJ-10 
University of Washington 
Seattle, Washington 98195 



management 

international 

review 



International Review for Management and Managerial 
Economics and Education 

In recent years a great deal of attention has been paid to those branches of 
learning which may have something to say to managers. While the economist 
has long shared the confidence of management, particularly in Germany, Italy, 
and the Netherlands, and while business economics and industrial economics 
have grown to be subjects in their own right, an equal interest is now arising, 
particularly in the English-speaking countries, in those aspects of management 
concerned with its human forces — with sociology, psychology, and the be- 
havior of organizations undergoing technological change. These are the 
domains of the so-called managerial sciences. The recognition of these as sub- 
jects in their own right is having profound effects upon the managerial out- 
look; in particular the development of formal and mathematical modes of 
thought — as in operations research — has thrown new light on the practical 
solution of many management problems. There is today a universal need to 
extend the use of these methods, but it is just as necessary that the mathe- 
matician know the practical needs of the manager as that the manager recog- 
nize the power of these new forms of analysis. What is to be desired 
throughout the field is an integrated outlook, calling for close collaboration 
between the scientists and the managers of all countries, and based upon 
sound bargaining between theory and practice. 

The magazine Management International Review would, on that account, 
claim to be the medium of exchange between practicing managers and re- 
search workers. It is devoted mainly to the nature and solution of manage- 
ment problems of business enterprises, corporations of public authorities, and 
other large-scale institutions. In addition, it gives particular attention to ideas 
and progress in the field of management education. 

Management International Review is addressed to practicing managers and 
active research workers, and it relies upon them for its published material. 
For it to develop as a medium of exchange it must first rely upon those who, 
from their experience or research, have something to contribute; it must be 
essentially the product of cooperation. 

Management International Review appears in three languages: English, 
French, and German. Each article will be published in the language chosen 
by its author. A summary will appear in the remaining languages. 

Annual subscription rate — DM 63 — including postal fees, published four 
times a year; all issues comprise at least 640 pages (size: 170 X 245mm). 

Betriebswirtschaftlicher Verlag Dr. Th. Gabler KG, 

P.O. Box 11, D 6200 Wiesbaden 1 (Federal Republic of Germany) 




Accounting in the 
Golden Age of Greece 



George J. Costouros 

Contemporary accounting theory and practice have been shaped by diverse 
economic and political influences. The increasing social importance of the 
accounting profession is indicated in many ways. In the United States, 
recent legislative studies by both houses of the Congress (the Cohen and 
Moss Reports) have examined critically the adequacy of the accoundng 
profession in the United States and its present structure to service ade- 
quately its several publics. In Great Britain, the problem of severe inflation 
and the perceived inadequacies of the existing accounting reporting theory 
and practice were extensively studied by the Royal Commission and its 
findings given in the Sandilands Report. 

An understanding of the origins and subsequent development of accounting 
theory and practice should be of vital importance in our attempts to assess 
present deficiencies in accounting and to identify promising changes in 
accounting services to its constituencies in the future. An important part 
of this understanding can be obtained from thorough studies of the devel- 
opment of accounting in specific important historical periods. 

The Center considers the exploration reported in The Role of Accounting 
in the Economic Development of England 1500-1750, by James O. Win- 
jum, as a particularly useful study for the long-term evaluation of account- 
ing development. We believe that Professor Costouros has added a concise 
and useful work to this larger continuing study of accounting development. 
He has examined basic goals and applications of accounting in one of 
history's pivotal periods. We believe this is a useful addition to the small 
but valuable work concerned with the international development of ac- 
counting thought. 



Copies will be available ($5.00) from the Center for International 
Education and Research in Accounting, 320 Commerce Building 
(West), Box 109, University of Illinois at Urbana-Champaign, Ur- 
bana, Illinois 61801 U.S.A. 




The Pagatoric Theory 
of Financial Income Determination 

Erich Kosiol 

With this work the Center brings to a large part of the international read- 
ing public the first exposition of a unique and important theory of accounts. 
Professor Kosiol, a uniquely gifted individual with long experience in both 
the academic and professional worlds, has throughout his creative lifetime 
perfected his pagatoric theory of financial statements. This monograph 
is his statement of that theory. 

Professor Kosiol had a unique opportunity to study with some of the lead- 
ing accounting theorists during his student years and became particularly 
aware of the two rather diametrically opposed theories of financial state- 
ments and underlying accounting data. He evolved his own special com- 
prehensive accounting theory structure. The reader will note that it is a 
thoroughly integrated theory which encompasses the wide variety of eco- 
nomic transactions which an enterprise may encounter. Professor Kosiol's 
pagatoric theory has been described by leading academicians as a unique 
logically integrated theory system and that it is the best known of such 
complete theory structures. Professor Kosiol's theory specifically includes 
the subjects of income determination as well as the theory of accounts, 
financial structures, and valuations theory. Professor Kosiol's productive 
life has had as a unique conceptual thread the continuing evolution and 
perfection of the pagatoric concept. 



Copies will be available ($5.00) from the Center for International 
Education and Research in Accounting, 320 Commerce Building 
(West), Box 109, University of Illinois at Urbana-Champaign, Ur- 
bana, Illinois 61801 U.S.A. 




Accounting for Common Costs 

and 

A Bibliography of Cost Accounting: 
Its Origins and Development to 1914 

M. C. Wells 

The Center for International Education and Research in Accounting has 
as one of its major purposes the publication of scholarly contributions in 
the field of international accounting. With the publication of this compre- 
hensive study by Professor Murray C. Wells, I believe the Center has 
published a seminal work. 

Professor Wells' scholarship is thorough and comprehensive. He has turned 
his efforts to one of the most difficult problems in accounting. His partic- 
ular area of concern is the important one of allocating "common overhead 
cost of products." Professor Wells has completed an exhaustive study of the 
literature in this area. We believe the reader will be given a useful explana- 
tion of the historical background and present discussion of accounting 
practice relating to overhead allocations. 

In addition to the monograph, Professor Wells has also compiled a com- 
prehensive bibliography of this topic. We believe it is the most comprehen- 
sive yet compiled and should serve accounting scholars well in the future. 
The bibliography is published in a companion volume and is an integral 
part of the research. 



Copies will be available from the Center for International Education 
and Research in Accounting, 320 Commerce Building (West), Box 
109, University of Illinois at Urbana-Champaign, Urbana, Illinois 
61801 U.S.A. (Price: $8.00 each or $14.00 per set.) 




The Impact of Inflation on Accounting: 

A Global View 



If one examines the long history of accounting, a focal point for continuing 
theory debate quite clearly has been in the area of valuation. More specif- 
ically, from accounting's very origins, the question of data in the accounts has 
been concerned with the original cost versus some other values. In modern 
times and for varying reasons given by many commentators, the question of 
recording values in the accounts has become more acute. In recognition of 
this growing debate which has a significant international impact, the Center 
planned a seminar with the theme, The Impact of Inflation on Accounting: 
A Global View. 

In 1978 we were in a period of continued extensive debate concerning the im- 
pact of inflation on accounting data. This is not a new discussion but perhaps 
it has become more intense or viewed more seriously than earlier. The many 
cylical economic periods centuries ago in Great Britain and Europe had their 
impact upon accounting. The French company laws, the German balance 
sheet laws, and the English Company Acts are all manifestations of attempts 
to legislate appropriate action where accounting data faces the disorganization 
or stress caused by fluctuating market valuations. It seemed most appropriate 
to take a new perspective in 1978 of the international debate centering on the 
impact of inflation on accounting. We were pleased to have extraordinarily 
capable speakers to talk on this topic. Dr. Sprouse of the Financial Account- 
ing Standards Board typified the type of scholar who gave presentations for a 
seminar of this type. Specific individual presentations in the seminar dealt 
with current concerns and current proposals in the inflation area. 

We do not presume that the debate of whether accounting data should be ad- 
justed or should reflect current market valuations has now been settled. We 
feel the problem is international in its importance and believe the pressures of 
inflation increase the pressure on accounting to attempt to provide a theory 
that will accommodate the specific reporting needs of a period of inflation. 
These pressures seem to vary directly with the rate of inflation. In the inter- 
national area we have had a number of specific cases where countries have 
experienced inflationary rates of such magnitude that the original cost frame- 
work accounting data obviously had to be supplemented or adjusted. 

We also attempted in the Index on Inflation to prepare a comprehensive 
bibliography on the inflation and accounting area of articles written during 
the past five years. We hope it will be useful to provide both specific refer- 
ence to key works and also to indicate the pervasiveness of various themes 
within this overall area of debate. 



Copies will be available ($6.00) from the Center for International 
Education and Research in Accounting, 320 Commerce Building 
(West), Box 109, University of Illinois at Urbana-Champaign, Ur- 
bana, Illinois 61801 U.S.A. 



You could do it 

or go right to the source. 




The 1979 AUBER Bibliography 



FACT: The AUBER Bibliography provides the researcher with 
information that is not found in standard indexes— namely 
monographs and working papers. 

FACT: Over 2,200 working papers, monographs, regional business 
reports, journals, conference reports, books, and technical 
reports produced by member institutions of the Associa- 
tion for University Business and Economic Research 
(AUBER) and the American Assembly of Collegiate 
Schools of Business (AACSB) are listed— 10% more than 
in last year's Bibliography. 

FACT: Information is listed in three different ways to facilitate 
research: by subject, institution, and author. If you miss a 
listing in one section, you'll catch it in another. 

FACT: Over the past 22 years, thousands of researchers, teachers, 
managers, public administrators, students, statisticians, 
librarians, and writers have used the AUBER Bibliography 
to locate the materials they need. 

FACT: At only $12.50, the AUBER Bibliography costs the same 
as it did in 1978. 

FACT: You can order your copy of the AUBER Bibliography, 
Volume XXIII, by sending a check for $12.50 made out 
to AUBER-WVU Bookstore and mailing it to the 

Bureau of Business Research 

209 Armstrong Hall 

West Virginia University 

Morgantown, WV 26506 



ONE YEAR'S SUBSCRIPTION TO THE INTERNATIONAL 
JOURNAL OF ACCOUNTING EDUCATION AND RESEARCH 

Volumes 1 through 12 (1965-77) $60.00 

Also available $5.00 per volume or 
$3.00 per single-copy issue 

Volumes 13 through 15 (1977-80) 30.00 

Also available $10.00 per volume or 
$5.00 per single-copy issue 

OTHER PUBLICATIONS OF THE CENTER FOR INTERNATIONAL 
EDUCATION AND RESEARCH IN ACCOUNTING 

A Statement of Basic Accounting Postulates and 

Principles (English or Spanish Edition) 1.00 

Theory of Accounts in Double-Entry Bookkeeping, 

by Karl Kafer 3.00 

The Evolution of Direct Costing, by Charles Weber 3.00 

The Nature and Stages of Accounting Development 

in Latin America, by Edward Elliott 4.00 

Input-Output Analysis and Its Application to Business 
Accounting, by Shawki Farag 4.00 

The Role of Accounting in the Economic Development 

of England 1500-1750, by James O. Winjum 4.00 

Accounting Research 1960-70: A Critical Evaluation, 

Nicholas Dopuch and Lawrence Revsine, editors 5.00 

Cost Terminology and Cost Theory: A Study of Its 
Development and Present State in Central Europe, 
by H. M. Schoenfeld 5.00 

The Pagatoric Theory of Financial Income 

Determination, by Erich Kosiol 5.00 

Accounting for Common Costs, by M. C. Wells 8.00 
A Bibliography of Cost Accounting: Its Origins and 

Development to 1914, by M. C. Wells 8.00 

Available as a set 14.00 

Accounting in the Golden Age of Greece: A Response 

to Socioeconomic Changes, by George J. Gostouros 5.00 

WRITTEN CONTRIBUTIONS OF SELECTED 

ACCOUNTING PRACTITIONERS 

Volume 1, by Ralph S. Johns 5.00 

Volume 2, by Paul Grady 8.00 

EDITED PAPERS OF INTERNATIONAL 

SEMINARS 

1977 — The Multinational Corporation: 

Accounting and Social Implications 6.00 

1978 — The Impact of Inflation on Accounting: 

A Global View 6.00 

CONTEMPORARY ISSUES IN INTERNATIONAL 
ACCOUNTING: OCCASIONAL PAPERS 

Status of Social Reporting in Selected Countries, 

by Estes, Jaruga, Schoenfeld, et al. 3.00 



ER FOR INTERNATIONAL EDUCATION AND RESEARCH IN ACCOUNTING 










JBRAKV Or 



T n _ iqpn 



' , ~ I3fl! 



J98( 







VOLUME 15, NUMBER 2, SPRING 1980 

THE 

INTERNATIONAL 

JOURNAL OF 

ACCOUNTING 

EDUCATION AND RESEARCH 



UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN 



CENTER FOR INTERNATIONAL EDUCATION AND RESEARCH 
IN ACCOUNTING OF THE COLLEGE OF COMMERCE 
AND BUSINESS ADMINISTRATION 

The Center for International Education and Research in 
Accounting was established to foster the international devel- 
opment of education and research in the accounting disci- 
pline, to provide a base for the international exchange of ideas 
and materials relating to accounting education, to encourage 
and assist both accounting faculty personnel and students 
from other countries to come to the University of Illinois at 
Urbana-Champaign for study and research in accounting, 
and to provide faculty members for assignment to universities 
in other countries. 

The center, functionally and administratively, is a constit- 
uent part of the Department of Accountancy and the College 
of Commerce and Business Administration of the University 
of Illinois at Urbana-Champaign. The graduate training of a 
substantial number of international students has been an 
important activity of the department for many years. 

One of the specific goals of the center is the publication of 
reports, booklets, and monographs which further the cause of 
advanced education and research in accounting. 

V. K. Zimmerman, Director 




THE 

INTERNATIONAL 

JOURNAL OF 

ACCOUNTING 

EDUCATION AND RESEARCH 



Volume 15 ■ Number 2 ■ Spring 1980 

CENTER FOR INTERNATIONAL EDUCATION AND RESEARCH IN ACCOUNTING 

UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN 

© 1980 by the Board of Trustees of the University of Illinois 



The International Journal of Accounting Education and Re- 
search is published semiannually, spring and fall, by the 
Center for International Education and Research in Account- 
ing. College of Commerce and Business Administration, Uni- 
versity of Illinois at Urbana-Champaign. Subscription rates 
are $10.00 per year. Single-copy price is $5.00. Copies of prior 
issues are still available. 

Manuscripts and communications for the editor and business 
correspondence should be addressed to The International 
Journal of Accounting Education and Research, 320 Com- 
merce Building (West), University of Illinois at Urbana- 
Champaign, Urbana, Illinois 61801. 

V. K. Zimmerman, Editor 
JaNoel S. Lowe, Assistant Editor 



Contents 



HARMONIZATION OF ACCOUNTING WITHIN THE EUROPEAN 

COMMUNITIES: THE FOURTH DIRECTIVE ON COMPANY LAW 1 

C. W. NOBES 

THE UNIT OF ACCOUNT IN CONSOLIDATED FINANCIAL STATEMENTS 

OF MULTINATIONAL ENTERPRISES 1 7 

MICHAEL H. JACOBI 

AN ANALYSIS OF CORPORATE SOCIAL REPORTING IN GERMANY 35 

BIKKI JAGGI 

A CROSS-SECTIONAL ANALYSIS OF QUALIFIED AUDIT REPORTS 47 

MICHAEL FIRTH 

INFORMATION CONTENT OF ACCOUNTING NUMBERS: EVIDENCE 

ON TOKYO STOCK EXCHANGE FIRMS 61 

KEIICHI KUBOTA 

INTERIM REPORTS AND THEIR QUALITATIVE EVALUATION 77 

A. J. ROBB 

FINANCIAL STATEMENT DISCLOSURE AND CORPORATE LAW: 

THE CANADIAN EXPERIENCE 87 

GEORGE J. MURPHY 

A COMPARISON OF PREPARATION FOR THE ACCOUNTING 

PROFESSION AMONG NEW ZEALAND, THE UNITED KINGDOM, AND 

THE UNITED STATES 101 

WILLIAM MARKELL 

THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENT IN 

COMMON STOCK: THE NEW ZEALAND EXPERIENCE 115 

G. GNIEWOSZ 

ACCOUNTING INFORMATION AND THE DEVELOPMENT 

PLANNING PROCESS IN KUWAIT 129 

SHUAIB A. SHUAIB 

THE ROLE OF ACCOUNTING IN PROJECT EVALUATION 

AND CONTROL: THE SYRIAN EXPERIENCE 143 

ADNAN ABDEEN 



Harmonization of Accounting within the European 
Communities: The Fourth Directive on Company Law 

C. W. NOBES* 



The pages of this journal have previously carried articles concerning 
accounting differences between the United States and various Euro- 
pean countries. 1 Also, harmonization within the European Eco- 
nomic Community (EEC) has been discussed. 2 However, much has 
happened in the last few years which merits additional comment. 
This article summarizes the main causes of present national differ- 
ences in accounting, discusses the purposes of harmonization, 
examines the EEC proposals for harmonization, and, finally, out- 
lines the British government's response, particularly to the EEC's 
Fourth Directive on Company Law of July 1978. 



CAUSES OF DIFFERENCES 

One basic cause of international differences in accounting is differing 
legal systems. The common law system of England and of most states 
in the United States involves a limited number of statutes supple- 
mented by a large volume of case law. However, continental legal 
systems, such as those of France and Germany, are based on a civil 
code which is prescriptive in a much more detailed manner than is the 



*C. W. Nobes is lecturer in accountancy at the University of Exeter, England. 
'N. M. Bedford and J. P. Gautier, "An International Analytical Comparison of the 
Structure and Content of Annual Reports in the EEC, Switzerland and the United 
States," International Journal of Accounting (Spring 1974); and P. E. M. Standish, 
"Accounting Responses to Inflation in the EEC," International Journal of Accounting 
(Fall 1975). 

2 R. A. Burnett, "The Harmonization of Accounting Principles in the Member 
Countries of the EEC," International Journal of Accounting (Fall 1975). 



2 INTERNATIONAL JOURNAL OF ACCOUNTING 



common law system. In such countries, the law precisely prescribes 
rules of asset valuation, income measurement, and the format of 
financial statements. Thus, there is little room for the "fair" presenta- 
tion which relies on more flexible rules and on an accounting 
profession trained and permitted to use judgment. Another reason for 
the comparative lack of importance of "fair" presentation in French 
and German accounting is that there are only approximately 900 
listed corporations in France and 500 in West Germany, compared to 
more than 3,000 in the United Kingdom and 2,500 in the United 
States. 3 In addition, much of the stock in the relatively few listed 
corporations in France and Germany is controlled by banks, 
governments, or families, all of whom have internal sources of 
information. Consequently, the remaining small number of private 
stockholders means a reduced need for the "fair" presentation. 

Traditionally, accounting in France and Germany has been per- 
formed primarily for the purposes of the revenue authorities and for 
government economic and statistical agencies. To a large extent, the 
profit amounts are the same for published accounting reports and 
taxation purposes, and auditing is mainly concerned with ensuring 
that the law has been obeyed and that taxable profit is correct. Partly 
for these reasons, the accounting profession in France and Germany 
is much smaller and performs different tasks from those of the profes- 
sion in the United States or the United Kingdom. 4 

The remarks concerning France and Germany apply, broadly 
speaking, to other continental European countries except for the 
Netherlands, where accounting and auditing are performed in a way 
which approximates the Anglo-Saxon approach. 5 It will be useful to 
recall this major difference between the accounting practices of 
continental countries and the Anglo-Saxon world (plus the Nether- 
lands) for the next section of the article. 

MAIN DIFFERENCES 

One fundamental difference in approach between continental and 
Anglo-Saxon accounting has already been mentioned: the importance 
of "fair" presentation in Anglo-Saxon accounting developed in part 
from the need to provide useful and comparable information to 
outside stockholders. Continental accounting involves many rigid 

*New York Stock Exchange Fact Book (1977). See also M. Lafferty, Accounting in 

Europe (London: Woodhead-Faulkner. 1975). 

4 C. W. N'obes. "Some Topics in International Accounting." International Accountant 

(February 1978 and April 1978). 

5 J. H. Beeny and J. G. Chastney. European Financial Reporting — Netherlands 

(London: ICAEVV. 1978). 



Fourth Directive on Company Laiv 3 



rules and the operation of "uniform accounting" which are useful for 
government and tax officials. The rigid rules are those established 
mainly by revenue law in France and by company law in Germany, 
for example, standardized formats, prescribed rates of depreciation, 
and rules of asset valuation. "Uniform Accounting," as described by 
Mueller, 6 for example, consists of detailed charts of accounts and 
many standardized definitions and measurement rules. In France, 
these are contained in the Plan Comptable General (General Ac- 
counting Plan) which is compulsory for companies and is supervised 
by a government body. 7 

A further important difference is the degree of conservatism. The 
strong influence of law and the importance of bankers and govern- 
ments as controllers of corporations help to explain the prevailing 
conservatism in continental accounting. Manifestations of this in- 
clude the general illegality of revaluing fixed assets; the compulsory 
increase of legal reserves from profit, typically 5 percent of yearly 
profit until reserves reach 10 percent of capital; and the prevalence of 
other reserves and allowances for price rises, risks, and possible losses 
in value. In Germany, for example, although income figures are not 
rounded to the nearest thousand as might be the case in the United 
States, they are often declared as round numbers ending in several 
zeros, making it clear that profit is a contrived figure and that reserves 
have been manipulated. Beeny uses the examples of several German 
companies, such as BASF, Salzgitten, and Feldmuhle, to illustrate 
this. For the information of investors and analysts, some German 
companies make more realistic estimates of income which may be 
many times higher. 8 

A third important difference has already been mentioned, that is, 
that continental corporate accounts must reflect any charges against 
taxable income in the accounting calculations. For example, al- 
though continental depreciation charges allowed for tax purposes are 
usually based on the lengths of useful lives of assets, there are 
occasions when a depreciation charge in the financial accounts is 
above what is "reasonable," in order to take advantage of accelerated 
tax allowances. In addition, tax regulations allow a variety of write 
offs and special reserves which must be reflected in the financial 
accounts if they are to be allowed for tax. 

Another important difference from the point of view of interpreta- 

6 G. G. Mueller, International Accounting (New York: Marmillan, 1967), pt. 1. 

7 J. H. Beeny, European Financial Reporting — France (London: ICAEW. 1976), ch. 4; 

and Lafferty, Accounting in Europe, ch. 2. 

8 J. H. Beenv, European Financial Reporting — Germany (London: ICAEW. 1976), ch. 

4. 



4 INTERNATIONAL JOURNAL OF ACCOUNTING 



tion of published accounts concerns consolidation. 9 Many French 
and most Italian groups do not provide consolidated financial state- 
ments. Those which do consolidate use a variety of practices, including 
variants of the parent company and equity methods, and completely 
different methods such as proportional consolidation. This situation 
results from a lack of legislation in the area and the absence of a strong 
accounting profession capable of formulating and enforcing its own 
rules. German groups are required by law to consolidate, but this 
extends only to domestic subsidiaries. There is no consolidation for 
foreign subsidiaries (unless the group voluntarily prepares additional 
statements) or for any associated companies (see following sections 
and note 16). 

These differences mean that great care must be used in comparing 
the accounts of, for example, Standard Oil, British Petroleum, and 
Total Oil (France). Such international comparisons between com- 
panies will usually involve the use of consolidated accounts. To a 
large extent, it is not possible to adjust accurately for the differences in 
consolidation techniques using only the information in company 
accounts from different countries. Clearly, the harmonization of con- 
solidation practices is very important. This is considered in a later 
section. 

Publication requirements also vary' by country. Those of the United 
Kingdom and Ireland are unusual in Europe because they do not 
exempt small companies from any publication of audit require- 
ments. This will probably be remedied when the Fourth Directive is 
brought into national law, as discussed later. 

Finally, the positions of the professions and governments through- 
out the EEC toward inflation accounting 10 vary widely. The British 
government is in favor of inflation accounting, but the profession 
finds it difficult to agree upon an acceptable version; some Dutch 
companies have been voluntarily using current value accounting for 
decades; the French government has recently rejected a proposal 
concerning supplementary current purchasing-power information; 
and the German government was so against inflation accounting for 
Germany and any other EEC country that approval of the Fourth 
Directive (which allows governments to introduce it) was placed in 
jeopardy. As yet, no government or professional body in the EEC has 
promulgated any standard practice in this area. This might be an area 



9 R. H. Parker, "Concepts of Consolidation in the EEC." Accountancy (February 1977). 
'"Following common (though inexact) practice, the expression "inflation accounting" 
is used to include systems which adjust for specific price changes as well as general 
inflation. 



Fourth Directive on Company Law 5 



which will cause even greater problems of harmonization. However, 
it is expected that a standard (SSAP 16) on supplementary current cost 
accounting will be issued in the United Kingdom March 31, 1980. 

THE PURPOSES OF HARMONIZATION 

Harmonization of accounting is a process whereby the size and 
number of differences in practice between countries are reduced. It 
does not imply complete standardization that would require uniform 
and rigid rules throughout the EEC. General arguments for the inter- 
national harmonization of accounting practices 11 include the useful- 
ness that this would have for investors, financial analysts, and credit 
agencies (for example, the World Bank) in assessing and comparing 
the performance and prospects of companies from different countries. 
Multinational corporations and international accounting firms would 
gain from having financial statements based on similar systems 
throughout the world to audit, consolidate, compare, and so on. Tax 
authorities would find it easier to assess foreign companies. Also 
governments, economic and statistical agencies, and trade unions 
would be better able to collect information and monitor the activities 
of corporations. 

On a worldwide basis, the International Accounting Standards 
Committee (IASC), the United Nations, and the Organization for 
Economic Cooperation and Development (OECD) 12 are among bodies 
interested in the harmonization of accounting for the reasons men- 
tioned earlier and, also, in the case of the latter two bodies, to enable 
greater control of multinational corporations. 

Within the EEC, in particular, harmonization of corporate 
accounting and taxation is an aim of the commission due to the 
objectives of the Treaty of Rome. These include the promotion of the 
free movement of persons, capital, goods, and services throughout 
the EEC. The free movement of capital requires the supply of reliable, 
homogeneous accounting information from EEC companies. This 
implies the harmonization of accounting. The free movement of 
persons and capital also requires the harmonization of direct taxa- 
tion. The commission, therefore, intends that companies of the same 
form which are in competition within the EEC will be subject to the 
same laws, taxes, accounting, and disclosure requirements. 



"International Centre for Research in Accounting, International Financial Reporting 
Standards, Occasional Paper No. 13 (Lancaster: ICRA. 1977). 

12 J. P. Cummings and M. N. Chetkovich, "World Accounting Enters a New Era," 
Journal of Accountancy (April 1978). 



6 INTERNATIONAL JOURNAL OF ACCOUNTING 



HARMONIZATION OF ACCOUNTING 



Although the professional bodies of manv countries in the EEC 
belong to the IASC, harmonization in the EEC will not be due to 
IASC's work, because company and revenue law in such countries as 
France and Germany is sufficiently weak that accounting standards 
can have little power in those countries. Therefore, harmonization 
results from new company law brought into effect as a result of EEC 
directives. The present list of relevant directives and draft directives is 
shown in exhibit 1. The most important directives for accounting are 
the fourth and the seventh (still in draft). 



Exhibit 1. Directives Relevant to Corporate Accounting 



Directives on 


Draft 


Date 




Company Law 


dates 


approved Purpose 


First 


1964 


1968 


Ultra vires rules 


Second 


1970, 1972 


1976 


Separation of private from 
public companies, 
minimum capital, limita- 
tion on distributions and 
interim dividends 


Third 


1970,1973,1975 


1978 


Mergers 


Fourth 


1971, 1974 


1978 


Formats and rules of 
accounting 


Fifth 


1972 




Structure, management, 
and audit of companies 


Sixth 


1972, 1975 




Prospectuses 


Seventh 


1976, 1978 




Group accounts 


Eighth 


1978 




Qualifications and work of 
auditors 



Regulations on Company Law 
Societas Europea 1970, 1975 



European cooper- 1973, 1978 
ation grouping 

Directives on corporate taxation 
Company 1975 

taxation 

Collective invest- 1978 
ment institutions 



Proposals for a European 
company subject to EEC 
laws 

Proposals for a business 
form facilitating multi- 
national joint ventures 

Harmonization of systems 
of company taxation and of 
withholding taxes 
Extends the 1975 directive 
to these special companies 



Fourth Directive on Company Law 7 



The Fourth Directive on Company Law was approved by the 
Council of Ministers of the EEC in July 1978. The first stage that the 
directive passes through is translation and checking by the "jurists 
and linguists" group. An example of the problems faced during this 
stage is that the British prefer the word "prudence" to the rather 
stricter "conservatism." However, the obvious translation of 
"conservatism" into French would be the French word prude nee. The 
directive must then be passed into law by the member states within 
two years. There is a further period of eighteen months for the 
national legislation to come into force. 

The original 1971 draft of the Fourth Directive and its much 
amended successor of 1974 which followed the accession of the United 
Kindgom, Denmark, and Ireland have been discussed elsewhere. 13 
The gradual move away from the domination of Franco-German, 
legalistic, uniform, conservative, creditor- and tax-based accounting 
continued between 1974 and 1978. The governments of the United 
Kingdom, the Netherlands, and Ireland successfully proposed that 
the "fair" presentation notion should predominate. Support for this 
view came from the Groupe d'Etudes (Accountants' Study Group, 
representing professional accountancy bodies in the EEC). 

The directive applies to all limited companies (and limited part- 
nerships), except banks and insurance companies for which there will 
be special directives. It proposes minimum standards only. For 
example, many member states of the EEC will require statements of 
the source and application of funds, even though the Fourth Directive 
does not. The directive's main concerns are valuation rules, formats, 
and contents of published financial statements, and publication re- 
quirements. Consolidation is left to the proposed Seventh Directive. 

Valuation will be performed using the historical cost basis. The 
conventions of the going concern, prudence, accruals, and consis- 
tency will be applied. The explicit statement of these conventions has 
been a change in the drafting. It parallels British and U.S. accounting 
standards. 14 There are detailed rules concerning the valuations of 
inventories, measurement of depreciation, and other similar matters. 
In general, these will not necessitate changes in practice. However, 
there is a requirement to write off purchased goodwill over five years 
(or a longer period, up to its useful economic life, if allowed by 
member states). This may change British practice. Also, exceptional 



"Burnett. "Harmonization." 

'Accounting Standards Committee, Disclosure oj Accounting Policies: SSAP 2 (U.K. 
Accountancy Bodies, 1972); and Accounting Principles Board, Basic Concepts and 
Accounting Principles, APB Statement No. 4 (U.K. Accountancy Bodies, 1970). 



8 INTERNATIONAL JOURNAL OF ACCOUNTING 



value adjustments must be separately disclosed. This includes any 
accelerated depreciation shown in the financial statements because 
this is necessary if it is to be allowed for tax purposes. This will lead to 
useful additional information in French and German financial 
statements. Similarly, the importance of secret reserves is diminished 
because all changes in valuation must pass through the income 
statement. 

One of the great problems encountered when trying to reach 
agreement among the member states of the EEC was inflation 
accounting. The different governmental attitudes have already been 
mentioned. The Fourth Directive compromises by allowing member 
states to ban, permit, or require inflation accounting. It may be as a 
replacement or as a supplement to historical cost accounting. No 
system is specified. In all cases, historical cost balance-sheet figures 
must still be disclosed. Thus, the directive allows the development of 
financial statements with dual sets of accounts, with different versions 
of inflation accounting used in different member states. This casts 
serious doubt on whether "reliable, homogeneous accounting infor- 
mation" will be available throughout the EEC. 

Published financial statements in the United Kingdom and the 
Netherlands (as in the United States) show very little standardization, 
whereas most continental European countries impose a considerable 
measure of uniformity. The Fourth Directive will force greater 
uniformity on the United Kingdon and the Netherlands with the 
objective of enhancing comparability. There will be one basic format 
for balance sheets, though member states may choose vertical or 
horizontal versions, or may allow both. Certain items must be shown 
on the balance sheet; other items may be grouped together (see next 
section). The income statement may be organized by type of expendi- 
ture or by stage of production. In each case, a horizontal or vertical 
format is allowed by the directive. The detail required will considerably 
exceed that published at present by British companies in their profit 
and loss accounts. In particular, the cost of goods sold will have to be 
shown. This will be welcomed by financial analysts. The general 
increase in uniformity, without complete rigidity, should make com- 
prehension of accounts by nonaccountants somewhat easier. 

As for disclosure in notes, there are many disclosures in U.S. and 
British financial statements not provided by those in most EEC 
countries. Many of these become necessary under the Fourth Directive, 
for example, average number of employees, financial commitments, 
directors' benefits, and turnover by category and area. 

Throughout most of the EEC (but not in the United Kingdom), 



Fourth Directive on Company Law 9 



publication requirements are relaxed for small or private companies. 
The directive (unlike the earlier drafts) makes no distinction between 
public and private companies. However, there are important distinc- 
tions based on size. Small companies are those which satisfy at least 
two of the following criteria: balance-sheet total < lm units of 
account (u.a.), 15 turnover < 2m u.a., employees < 50. Such small 
companies may be permitted by member states to publish an abridged 
balance sheet without an income statement, and to avoid an audit. 
Medium-sized companies are those which satisfy at least two of these: 
balance-sheet total < 4m u.a., turnover < 8m u.a., employees < 250. 
These companies may be permitted to abridge their balance sheets 
and to omit the detail of the calculation of gross earnings in their 
income statements. If the British government takes advantage of 
these provisions, there will be considerable advantages for smaller 
companies. 

An important new provision in the final directive is the establish- 
ment of a "contact committee" to deal with problems arising with the 
implementation, and suggestions for amendments. This may help to 
reduce the problems of inflexibility, which have been a particular 
concern of British accountants not accustomed to detailed prescrip- 
tions in company law. Nevertheless, the directive has already been 
criticized in the United Kingdom for being too creditor biased, and 
doubt has been cast on the usefulness of harmonizing historical cost 
accounting. 

The important remaining aspect of the harmonization of consoli- 
dation practices awaits the approval of the Seventh Directive. The 
present draft proposes that subsidiaries (both domestic and foreign) 
shall be consolidated using the parent-company concept, and that 
associated companies 16 shall be treated by the equity method. 

This appears very similar to British practice, but there are some 
important differences. The definition of an associated company is in 
line with British practice (that is, a 20 percent or higher holding, or a 
joint-venture arrangement). However, the concept of a subsidiary 
follows German practice and relies on the existence of control "on a 
unified basis," rather than on percentages of stockholdings. Also, 
proportional consolidation may be allowed by member states for 
joint ventures. 

Finally, it is proposed that "horizontal consolidation" will be 



15 The European unit of account is based on a basket of EEC currencies. For approxima- 
tions, the unit of account may be taken to be between 1 and 1.5 U.S. dollars. 
16 "Associated company" is a British expression used to denote those companies which 
are treated by the equity method of consolidation. 



10 INTERNATIONAL JOURNAL OF ACCOUNTING 



necessary for companies within the EEC which are independent of 
each other but are owned by the same parent outside the EEC. For 
example, if a U.S. -based multinational company has subsidiaries in 
the U nited Kingdom, France, and Germany, these subsidiaries jointly 
would have to prepare one set of "consolidated" EEC accounts even 
though none of them had any control over any other. 

NEW BRITISH COMPANY LAW 

In September 1979, the British government issued a Consultative 
Document (or "Green Paper") called "Company Accounting and 
Disclosure." 17 Its purpose is to announce the government's proposals 
on the reform of company law, in particular those changes which will 
be necessary to implement the Fourth Directive. It is intended that 
British companies shall have the maximum flexibility permitted by 
the directive (Green Paper, part B, II, iii). This is evidenced, for 
example, by the proposals on formats. Both of the two balance-sheet 
formats in the directive, and any of the four profit and loss formats are 
to be allowed (see exhibits 2 and 3). 

To understand the Green Paper's proposals on formats, two further 
concepts which are quite new for the United Kingdom must be 
discussed. As mentioned in the previous section, the directive allows 
member states to introduce reduced disclosure for smaller companies. 
The British government intends to take advantage of this. The 
suggested definitions can be seen in the first row of exhibit 4. The 
second concept is the difference between financial statements which 
are "drawn up" for shareholders, and those which are "published" 
and sent to the registrar of companies. Small companies will be 
required to disclose less than large companies; there are to be greater 
relaxations for published accounts than for drawn up accounts. 
Exhibit 4 summarizes the publication proposals. 

This new proposed distinction between companies, based on size, 
will be a major innovation for British company law. The expression 
"proprietary company" will provide a useful label for small private 
companies. It is not yet clear whether the government will take 
advantage of the option in the directive to reduce the scope of audits 
for proprietary companies. If it does, a "review" will still be necessary 
(part A, chapter II). 

The Green Paper announces the intention to introduce extra 
disclosure requirements for large companies: funds-flow statements 



''Department of Trade. Company Accounting and Disclosure (London- H M S O. 
1979). 



Fourth Directive on Company Law 11 



Exhibit 2. A Proposed U.K. Balance Sheet 



A. Subscribed capital called but not paid 
C. Fixed assets 

I. Intangible assets 

Preliminary expenses 

1. Costs of development 

2. Concessions, patents, licences, trademarks, etc. 

3. Goodwill 

4. Payments on account 

II. Tangible assets 



4. 



Land and buildings 

Plant and equipment 

Other fixtures and fittings, tools, 

and equipment 

Payments on account, and tangible assets 

in course of construction 



x 

X 
X 
X 

X 

XX 



III. Investments 

1. Shares in group companies 

2. Loans to group companies 

3. Participating interests 

4. Loans to undertakings with which the 
company is linked by virtue of participating 
interests 

5. Investments held as fixed assets 

6. Other loans 

7. Own shares 

D. Current assets 
I. Stocks 

1. Raw materials and consumables 

2. Work in progress 

3. Finished goods and goods for resale 

4. Payments on account 

II. Debtors* 

1. Trade debtors 

Amounts owed by group companies 

Amounts owed by undertakings with which 

the company is linked by virtue of 

participating interests 

Other debtors 

Subscribed capital called but not paid 

Prepayments and accrued income 



2. 



x 
x 

X 

XX 



X 
X 
X 

X 

XX 



X 
X 

X 

XX 



12 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 2. (cont.) 



III. Investments 

1. Shares in group companies 

2. Own shares 

3. Other investments 

IV. Cash at bank and in hand 

E. Prepayments and accrued income 



x 
x 

X 

XX 
XX 



F. Creditors: amounts becoming due and payable within 
one year 

1. Debenture loans, showing convertible loans (x) 
separately 

2. Bank loans and overdrafts (x) 

3. Payments received on account of orders (x) 

4. Trade creditors (x) 

5. Bills of exchange payable (x) 

6. Amounts owed to group companies (x) 

7. Amounts owed to undertakings with which (x) 
the company is linked by virtue of 

participating interests 

8. Other creditors, including tax and (x) 
social security 

9. Accruals and deferred income (x) 

Jxx) 

G. Net current assets liabilities xxx* 
H. Total assets less current liabilities 

I. Creditors: amounts becoming due and payable after 
more than one year 

1. Debenture loans, showing convertible loans (x) 
separately 

2. Bank loans and overdrafts (x) 

3. Payments received on account of orders (x) 

4. Trade creditors (x) 

5. Bills of exchange payable (x) 

6. Amounts owed to group companies (x) 

7. Amounts owed to undertakings with which (x) 
the company is linked by virtue of 

participating interests 

8. Other creditors, including tax and (x) 
social security 

9. Accruals and deferred income (x) 



(xxxx) 



Fourth Directive on Company Law 13 



Exhibit 2. (cont.) 



£ 



J. Provisions for liabilities and charges 

1. Provisions for pensions and similar 
obligations 

2. Provisions for taxation, including deferred 
tax 

3. Other provisions 

K. Accruals and deferred income 



L. Capital and reserves 

I. Subscribed capital called up 

(of which £ has been paid up) 

II. Share premium account 

III. Revaluation reserve 

IV. Reserves 

1. Capital Redemption Reserve Fund 

3. Reserves provided for by the Articles of 
Association 

4. Other reserves 

V. Profit (loss) brought forward 
VI. Profit (loss) for the financial year 



(x) 
(x) 
ix) 



(xxxx) 

(xxxx) 

xxxx 



•Amounts due in less than one year and more than one year to be shown separately in respect of each 

heading. 

"Total current assets. 

"•Current assets less creditors becoming due and payable within one year. 

Source: Department of Trade, Company Accounting and Disclosure (London: H. M. S. O.. 1979), 

Chapter III. 

Note: The lettering and numbering in exhibits 2 and 3 are those adapted by the British government 

from the fourth directive. Hence certain letters or numbers are omitted or repeated. 

(not reqtiired by the directive), and notes on short-term borrowings, 
leasing arrangements, pension commitments, and disaggregation of 
turnover (sections v to vii of chapter VI). As expected, the government 
intends to allow revaluations of assets and full current cost account- 
ing, as permitted by Article 33 of the directive. 



OTHER DIRECTIVES AND REGULATIONS 



Exhibit 1 shows a considerable list of EEC directives and regulations, 
which are mainly still in draft form. The most important directives 
on company law are the fourth and seventh, discussed earlier. The 
others are briefly described in exhibit 1. 



14 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 3. A Proposed U.K. Profit and Loss Account 



1. Turnover xxx 

2. Cost of sales (xxx) 

3. Gross profit loss 

4. Distribution costs 

5. Administrative expenses 

6. Other operating income 

— Operating profit loss 

7. Dividends from subsidiaries 

7. Dividends from participating interests 

8. Interest on loans to group companies 
8. Interest on other loans 

10. Amounts written off investments 

11. Interest payable to group companies 

11. Other interest payable 

— Profit loss before tax 

12. Corporation Tax 

13. Profit/loss after tax 

14. Extraordinary income 
17. Less: tax thereon 
19. Profit loss for the year 

Source: Department of Trade, Company Accounting and Disclosure (London: H.M.S.O., 1979). 
Chapter III. 





xxx 




(xxx) 




(xxx) 




xxx 




xxx 


X 




X 




XX 




X 




X 




XX 






(xxx) 


(x) 




(x) 


(xxx) 




xxx 




(xxx) 




xxx 


X 




(x) 


xxx 




xxx 



Regulations become law throughout the EEC without the need of 
action by the legislatures of member states. There are two draft 
regulations of relevance here. The draft regulation for a European 
company (Societas Europea) is moving slowly, particularly because 
of disagreements as to employees on boards of directors. It would 
create a business form subject to EEC law and taxation rather than to 
those of member states. No agreement is in sight. There is more likely 
to be agreement on the draft regulation on the European Cooperation 
Grouping. This regulation would facilitate the creation of a business 
form suitable for multinational temporary joint ventures within the 
EEC. 

The draft directive on the harmonization of corporate taxation 
proposes the adoption of an imputation system of corporation tax 
throughout the EEC with rates between 45 and 55 percent, and tax 
credits between 45 and 55 percent of the underlying corporation 
tax. Progress will also be slow on this directive. There are no plans to 



Fourth Directive on Company Law 15 



Exhibit 4. Green Paper's Publication Proposals 



Large 



Medium 



Small 
"proprietary' 



1. Definitions 



2 out of 3 size 



2. Balance sheet 
drawn up for 
shareholders 

3. Balance sheet 
published 



All listed 



Others with: 

Turnover 

>£5m 

B.S. >jT2.5m 

Employees 

>250 

May show 

Arabic numeral 

headings in 

notes 

As above 



4. Profit and loss Flexible 
account drawn up arrangement 
for shareholders 

5. Profit and loss As above 
account published 



All public not 
large 

All private not 
small 



May show 
Arabic numeral 
headings in 
notes 
As above 



Flexible 
arrangement 

As above, and 
possibly com- 
bine 1-5 in 
exhibit 3 



Turnover 

<£1.3m 

B.S. <£0.65m 

Employees <50 



May omit some 
Arabic numeral 
headings 

May omit Arabic 

numeral 

headings 

Possibly 

combine 1-5 in 

exhibit 3 

Exempt 



harmonize the calculation of taxable income, which is defined very 
differently in different member states. The latter point renders the 
proposals somewhat cosmetic. This draft directive is discussed by this 
author elsewhere. 18 



SUMMARY 

The passing of the Fourth Directive into national company law 
throughout the EEC should narrow some of the important differ- 
ences in accounting outlined earlier. The "fair" presentation should 
take precedence over detailed rules; conservative allowances in excess 
of reasonable estimates will be separately declared; and the effects of 
taxation on accounting expenses will also be separately declared. In 
addition, the formats of published financial statements will become 



18 C. W. Nobes, "Corporation Taxes in the EEC, and Their Harmonization,' 

Accountancy (October 1978). 



16 INTERNATIONAL JOURNAL OF ACCOUNTING 



more standardized throughout the EEC, and corporations of similar 
sizes will be subject to similar publication requirements. When the 
Seventh Directive is finalized by the Council of Ministers, there 
should be considerable harmonization of practices within the 
important area of consolidation. 

Nevertheless, it is likely that substantial diversity (both between 
and within countries) will still be possible within the national laws 
which will eventually be passed. Supporters of the view that rigid 
uniformity merely masks a multitude of differences will be happy 
with this. However, the possibility of different inflation accounting 
systems of varying prominence in difference EEC countries may 
destroy any hopes of simple comparability. 



The Unit of Account in Consolidated Financial 
Statements of Multinational Enterprises 

MICHAEL H. JACOBI* 



The treatment of fluctuating currencies in the financial statements of 
multinational enterprises (MNE) is probably the most highly debated 
current question in accounting for multinational activities. In fact, 
the float of currencies has become one of the major obstacles of 
international business in general. Exhibit 1 reports the magnitude of 
the changes in exchange rates during the seventies. 

To date, discussions in financial accounting have centered on the 
question of translating foreign-currency balances and foreign- 
currency denominated financial statements into domestic-currency 
denominated statements, primarily for consolidation purposes. 
However, for several years some companies have become increasingly 
aware of the fact that the overall positive local developments (of their 
subsidiaries) can turn into negative results upon consolidation. 
Dutch, German, and Swiss companies, particularly, were forced to 
notice this problem. 

The basic question for these companies is which is the correct fact, 
the positive local one or the negative consolidated one. This question 
leads directly to the underlying problem of the unit of account in the 
consolidated financial statements of multinational enterprises. Is it 
possible to provide a "true and fair view" of the activities of an 
American MNE by accounting in U.S. dollars? 

The discussion of this question begins with two examples which 
illustrate the second question. 1 



•Michael H. Jacobi holds a Dr. oec. degree and is associated with a Swiss multinational 
chemical company. 

'To avoid the criticism that we exaggerate the distortions, we used real world data as 
much as possible. 



18 INTERNATIONAL JOURNAL OF ACCOUNTING 



revaluations against the U.S. $ (X) ' 


devaluations a. U.S. $ (X) 




c 

3 ° 




a> a. 

5 






■■HH 






















c 
■6 ™ 






o 


m 


o 

3 




ian 
ra 

ainst 
ainst 






Ita 
li 

tion ag 
tion ag 



z 



c " 



x u 



Unit of Account in MNE Financial Statements 19 



CASE 1 



The accounts of Company A in nation NA and of Company B in 
nation NB must be consolidated. The exchange rates between the 
currencies of NA, local currency of A, LCA, and that of NB, LCB, 
were/are 



in 1972, 1 LCA 
in 1976, 1 LCA 
in 1977, 1 LCA 



3.8 LCB 
2.5 LCB 
2.0 LCB. 



After all intercompany transactions have been eliminated, each single 
company shows the following local balance sheets in 1977: 

Balance sheet of A (Billions LCA) 



Current assets 




Liabilities 




Monetary 

Inventory 

Fixed assets 


0.49 
0.31 
0.64 


Short term 
Long term 
Equity 


0.29 
0.30 
0.85 


Balance 


sheet of 


B (Billions LCB) 




Current assets 




Liabilities 




Monetary 

Inventory 

Fixed assets 


2.08 
1.21 
2.19 


Short term 
Long term 
Equity 


1.04 
1.42 
3.02 



If we calculate three important ratios, we find the following local 
results: 

Company A Company B 

Current ratio (current assets/liabilities) 2.76 3.16 

Debt/equity ratio (%) 69.4 81.5 

Fixed assets covered by equity (%) 75.3 72.5 

If we combine both balance sheets by translating the respective 
amounts in the balance sheet of one company into the currency of the 
other company using the monetary-nonemonetary approach, that is, 
we determine that 



3 The exchange rates employed are the Swiss franc U.S. dollar rates at the end of 1972, 
1976, and 1977. Figures in the "single company" balance sheets stem from (he 1977 
annual reports of Dart ("A") andSandoz ("B"). To simplify, figures were rounded and 
grouped together. The selection of these two companies is accidental and does not 
imply any real connection between Sandoz and Dan. 



20 INTERNATIONAL JOURNAL OF ACCOUNTING 



Fixed assets and equity are translated at 1 LCA = 3.8 LCB; 
Inventories are translated at 1 LCA = 2.5 LCB; and 
All monetary items are translated at 1 LCA = 2.0 LCB. 

The resulting consolidated balance sheets in currencies of LCA and 
LCB are shown below (the balance sheet expressed in currency X 
should be ignored for the time being). 



Consolidated Balance Sheet (Billions LCA) 


Current assets 




Liabilities 


Monetary 


1.53 


Short term 0.81 


Inventory 


0.79 


Long term 1.01 


Fixed assets 


1.22 


Equity 1.64 
Translation gain 0.08 



Consolidated Balance 


Sheet (Billions LCB) 


Current assets 




Liabilities 


Monetary 


3.06 


Short term 1.62 


Inventory 


1.99 


Long term 2.02 


Fixed assets 


4.62 


Equity 6.25 


Translation loss 


0.22 





Consolidated Balance Sheet (Billions X) 



Current assets 




Liabilities 




Monetary 


1.26 


Short term 


0.67 


Inventory 


0.69 


Long term 


0.84 


Fixed assets 


1.12 


Equity 


1.52 






Translation gain 


0.04 



Ratio analysis now provides the following results: 



Current ratio 

Debt equity ratio (excluding 

translation gains losses) % 
Debt equity ratio (including 

translation gains losses) % 
Fixed assets covered by equity 

(excluding translation gains 

losses) % 
Fixed assets covered by equity 

(including translation gains 

losses) % 



In 


In 


In 


currency 


currency 


currency 


LCA 


LCB 

3.12 


X 


2.86 


2.91 


110.9 


58.2 


99.3 


105.8 


60.4 


97.4 



74.9 



70.9 



73.9 



76.6 



73.7 



71.8 



Unit of Account in MNE Financial Statements 21 



Apparently, no ratio is strictly comparable if different units of 
account are used. The same value in ratio analysis means different 
things, for example, a return on investment (ROI) of 5 percent of an 
American MNE is not comparable to a ROI of 5 percent of a German 
MNE. In practice, an analyst will not be able to calculate what the 
balance sheet would be if expressed in a different unit of account, 
because neither all historic rates applied nor the amounts translated 
under each rate are disclosed. Therefore, an analyst cannot adjust 
ratios to make them comparable. For example, he will not be able to 
calculate the U.S. dollar equivalent of a ROI of 5 percent which is 
derived from a deutsche mark-denominated set of financial 
statements. 

CASE 2 

Let us assume that a MNE has the following sales (as expressed in 
local currencies). 4 



















Total 


















change 


Sales in 


M.D. 


1972 


1973 


1974 


1975 


1976 


1977 


(%) 


1'nited States 


l'S$ 


562 


585 


771 


863 


960 


954 


+ 70 


Germany 


DM 


596 


705 


786 


750 


845 


880 


+ 48 


United Kingdom 


£ 


72 


80 


93 


103 


138 


164 


+ 127 


France 


FF 


772 


893 


1,020 


1.027 


1.114 


1.220 


+ 58 


Italy 


Lira 


80.557 


92.437 


112.014 


122,987 


166,533 


182.078 


+ 126 


Japan 


Yen 


23.541 


30,262 


33.430 


42,554 


50,973 


52,972 


+ 125 


Spain 


Pta. 


3.713 


4,419 


5,389 


5,574 


7.129 


8,137 


+ 119 


Canada 


CDS 


55 


65 


79 


101 


102 


113 


+ 105 


Brazil 


Crz. 


345 


490 


674 


1,040 


1,759 


2.619 


+ 659 


Switzerland 


SRF 


206 


196 


229 


201 


222 


218 


+ 6 


Mexico 


Peso 


521 


631 


814 


938 


1.181 


1.719 


+ 230 


Australia 


A$ 


31 


35 


39 


41 


46 


52 


+ 68 



Now we consolidate these sales using the exchange rates applicable 
into U.S. dollars, pounds sterling, deutsche marks, and Swiss franks 
(X should be ignored for the time being). 5 



4 The sales volumes expressed in local currencies (except "total change") stem from the 
annual reports of CIBA-GEIGY and represent sales in certain major countries. See 
CIBA-GEIGY, Annual Reports 1972 through 1977. p. 11. 

Consolidated sales as expressed in this table do not match with CIBA-GEIGY's total 
sales since our table only adds up those sales disclosed above. Furthermore, such a 
translation should be conducted at year's average rates. However, in order to provide 
comparable results with the data translated into X, all amounts were translated using 
year's end rates. Using year's average rates would not alter the underlving fundamental 
question. The "total real change" was calculated by comparing the 1977 sales with the 
restated sales of 1972 (restated according to the change in the consumer price index). 
Sources as in footnotes 1 and 4. 



22 INTERNATIONAL JOURNAL OF ACCOUNTING 



















Total 


Total 


















nominal 


real 


Total 


Consolidated sales 


1972 


1973 


1974 


1975 


1976 


1977 


charge 


charge 


is S 


Amounts Change 


1,591 


1.866 


2.301 


2.415 


2.689 


2.985 








in % 




+ 17 


+23 


+ 5 


+ 11 


+ 11 


+88 


+29 


£ 


Amounts Change 


678 


803 


980 


1.193 


1.580 


1.566 








in % 




+ 18 


+22 


+22 


+32 


-1 


+ 131 


+ 9 


DM 


Amounts Change 


5,094 


5.044 


5.544 


6.333 


6.352 


6.283 








in % 




-1 


+ 10 


+ 14 





-1 


+23 


-6 


SFR 


Amounts Change 


6.004 


6.053 


5.845 


6.327 


6.589 


5,970 








in % 




+ 1 


-3 


+ 8 


+ 4 


-9 


-1 


-24 


X 


Amounts Change 


1.465 


1.547 


1.879 


2.063 


2.314 


2.457 








in % 




+ 6 


+21 


+ 10 


+ 12 


+ 6 


+68 


+ 7 



This comparison implies that a Swiss company with a slight 
decrease in sales over a six-year period is better off than an American 
company with an average annual increase in sales of 13 percent. Even 
if consolidated sales are adjusted for the differences in inflation rates 
in these countries, significant differences in trends of sales volume 
remain. Would an analyst realize this fact? Or would he praise the 
U.S. company for showing a steady growth rate and speak of an 
"under-the-given-situation satisfactory" performance of the Swiss 
enterprise? Would the management of such companies realize this or 
would a Swiss company's management make strong efforts to over- 
come this "stagnation" of sales while an American company's man- 
agement would be quite satisfied with the company's growth rate? 
Did sales "grow," "stagnate," or "shrink"? The answer to this 
question is likely to affect business decisions materially. 

The conclusions suggested by these two examples are disturbing. 
Even if one neglects national differences in accounting principles, 
one must realize that the financial statements of MNEs are not 
comparable merely because they are denominated in different curren- 
cies. Trends reverse across "currency-borders," and decreases of sales 
in one unit of account become more attractive than considerable in- 
creases in other units even if the data are inflation adjusted. Clearly, 
the aim of providing a "true and fair view" can hardly be achieved 
under these circumstances. 

WHY PRESENT STATEMENTS IN THE "DOMESTIC CURRENCY"? 

With very few exceptions, MNEs today use the currency of the parent 
company's country of domicile (the "domestic currency") as the unit 
of account in consolidated statements. Two major reasons are 
advanced for this practice. 



Unit of Account in MNE Financial Statements 23 



1. Investors in the equity of the parent company are often regarded as 
the sole audience of interest for the annual reports. Therefore, any 
information given is meant to explain the situation in the currency of 
this audience of interest. Since investors are thought to be almost 
entirely of "domestic" nationality, financial statements should be 
stated in the domestic currency: "An American MNE informs its 
shareholders through its annual report. Since these investors are 
almost entirely Americans, financial statements should be expressed 
in U.S. dollars." 

Also behind this attitude is the basic idea that any activity engaged 
in is solely conducted to increase the parent company's profit: "The 
ultimate reason for making foreign as well as any other kind of 
investment is to increase domestic general purchase power." 6 

2. The managements of MNEs do not realize the distortions which 
stem from fluctuating exchange rates. The whole issue of floating 
exchange rates is a rather new phenomenon. Its consequences are 
probably not fully seen at present. Furthermore, today's MNEs are 
companies which evolved from national into international multi- 
national firms. Perhaps their managements did not fully realize the 
impacts of this evolution and continue to evaluate business oppor- 
tunities from a domestic viewpoint: "Management is accustomed to 
thinking, measuring, and making decisions in terms of dollars." 7 
"Top managements are often single-currency conscious. Translation 
of accounts fosters this attitude and sometimes leads to, let us say, 
U.S. -dollar oriented decisions when Mexican-peso oriented decisions 
are really called for." 8 

ARE THESE ARGUMENTS VALID? 

For several reasons, the author does not consider that these arguments 
provide sufficient justification for selecting the domestic currency as 
the unit of account to be used for financial statements. 

1 . Domestic investors in the equity of the parent company are by no 
means the only audience of interest of consolidated financial state- 
ments of a MNE. Instead, practical experience in an international 
environment clearly indicates the opposite — that it is wrong to 

6 R. Gayton, "A Critical Examination of Presently Accepted International Accounting 

Translation Techniques" (Ph.D. dissertation. University of California, Berkeley, 

1973). p. 236. 

7 P. Rosenfield. "Accounting for Foreign Branches and Subsidiaries," International 

Journal of Accounting (Spring 1972): 44. 

8 Gerhard G. Mueller, International Accounting (New York: Macmillan. 1967), pp. 

208-13. 



24 INTERNATIONAL JOURNAL OF ACCOUNTING 



assume that, for example, all the shareholders of an American parent 
company of a MNE are Americans. After all, the stocks of some 200 to 
300 American companies are listed on foreign stock exchanges to 
attract foreign investors. 9 For such foreign shareholders, figures 
expressed in U.S. dollars might be misleading because these readers 
would analyze U.S. dollar-denominated financial statements and 
compare them with local ones. 

Experience also shows that the American interpretation of in- 
vestors in general being the sole audience of interest of annual 
reports 10 is too simplistic in an international environment. Creditors, 
governments, and employees have become especially important 
audiences as well. 

a. The wish of creditors to "protect their credits" has strongly 
influenced German accounting rules. 

b. French accounting and reporting rules have been modified 
recently so that they respond better to the information needs of trade 
unions. The disclosure of data concerning "social accounting" ques- 
tions is now required. 

c. In England, the Ford Company's subsidiary had to experience the 
unpleasant situation of a trade union challenging its (inflation- 
adjusted) accounts and preparing a different set of statements for 
negotiation purposes. 

d. The government's interest in annual reports is clearly illustrated 
by its involvement in the standard-setting process in countries such as 
Germany, France, Japan, and Switzerland. In international account- 
ing, the activities of the European Economic Community [EEC], the 
Organization for Economic Cooperation and Development [OECD], 
and the United Nations [UN] have underlined these interests as well. 

Therefore, we must conclude that, in reality, annual reports of 
MNEs inform different groups of readers. They have different interests 
and are located in different nations. By using the domestic currency as 
the unit of account, these differences are neglected, and biased state- 
ments favoring domestic audiences are published. 
2. The argument that the domestic currency is the correct unit of 
account because the ultimate aim of investments is to increase 



9 At the end of 1977. there were almost 2,000 listings of foreign stock at eighteen major 
stock exchanges. A minimum of 589 companies from forty-three countries was 
involved, of these at least 170 American. The total figure of companies having shares 
listed abroad probably lies around 800. See Michael Jacobi, "Probleme der Ausges- 
taltung internationaler Jahresabschlussvorschriften" Band 41. Schriftbenreihe der 
Schweizer. Treuhandund Revisionskammer, Zurich 1979, p. 50. 
10 For example, Financial Accounting Standards Board, Scope and Implications of the 
Conceptual Framework Project (Stamford, Conn.: FASB. 1976), p. 58. 



Unit of Account in MNE Financial Statements 25 



domestic purchasing power seems to be unrealistic and probably 
violates the going-concern principle. It seems to be unrealistic be- 
cause under normal circumstances, a large share of worldwide profits 
is reinvested directly without really reaching the parent company at 
all. Often, such funds are channeled to the next investment oppor- 
tunity via intermediate holding companies or cash centers. 11 Only a 
certain amount of total profits is repatriated and only part of this is 
paid to stockholders. A method which unrealistically assumes that 
100 percent of all profits are repatriated and paid must lead to 
unrealistic results. 

It might be argued that the preceding argument reflects a short- 
term view, while in the long run, profits really are repatriated and 
paid. This might be true, but it is irrelevant for accounting purposes 
for the following reasons. 

a. If the definite date for repatriation (of the then-invested capital) is 
known, we would have to treat said company as a liquidating (not a 
going) concern and use equivalent valuation methods. This situation 
is not normally assumed. 

b. If no definite date of repatriation is known, we must accept this 
fact and assume that the business is a going concern, continuing its 
operations in a similar way as before. For MNEs, the going-concern 
principle implies that the company will remain active in several 
countries (although not necessarily in those countries in which the 
company now operates). A going-concern MNE remains multi- 
national by definition. 

However, if we assume that the MNE remains multinational, we 
cannot choose accounting methods which indirectly imply that 
foreign operations are stopped, something we do if we assume that all 
profits (and all capital) are repatriated. 

3. Whether the management of a MNE evaluates business oppor- 
tunities from a domestic or from a different viewpoint will be 
discussed later. However, the author should like to point out that it is 
almost impossible for a MNE to make decisions completely from a 
parent-company viewpoint. Although the degree of importance of 
the parent company might differ — U.S. companies are often more 
centralized than other enterprises and thus are more likely to evaluate 
the business from a domestic viewpoint and in domestic currency — 
considerations of the impact of certain decisions on the local situa- 
tion will always be part of the overall decision-making process in a 
MNE. The postulate of "going native" unavoidably leads to the 

"See F. Weston and B. Sorge, I?iternatio?ial Managerial Finance (Homewood, 111.: 
Richard D. Irwin), pp. 239-40. 



26 INTERNATIONAL JOURNAL OF ACCOUNTING 



question "How does decision X affect the local situation of our 
subsidiary and its local financial statements?" Therefore, the overall 
decision-making process in a MNE will always be a multicurrency 
one, although more or less biased favoring the domestic currency. 

WHICH ALTERNATIVES EXIST? 

Few alternatives have been discussed in accounting theory thus far. 
Let us briefly examine some alternatives which Mueller identifies. 12 

The Legal Basis 

One might use a certain currency as the unit of account because it is 
the currency of the country in which the parent company has its legal 
domicile. In this case, however, we run the risk of preferring "form 
over substance." Especially with MNEs, legal structures differ 
materially from the organization, decision-oriented structure of the 
group. 

A variety of reasons can be given for certain legal structures — for 
example, tax considerations and other legal requirements (disclosure) 
or historical trends and events (mergers across borders). Well-known 
cases in which the legal structure differs significantly from the 
economic (decision-oriented) one include companies such as these: 
Nestle, which is a MNE with one legal headquarters in Switzerland 
and one in Panama; Hoffmann-La-Roche, a MNE with one legal 
headquarters in Switzerland and another in Canada; Royal-Dutch/ 
Shell, where the parent companies of the group are the British Shell 
T & T and the Dutch Royal Dutch N.V.; Unilever, where the parent 
companies are the British Unilever Ltd. and the Dutch Unilever N. V.; 
Agfa-Gevaert, where the parent companies are the German Agfa and 
the Belgian Gevaert companies; and Schlumberger, which relocated 
its legal headquarters in the Netherlands Antilles. Implying that only 
one currency (and if so, which?) has entered the decision-making 
process would be rather misleading in such cases. Legal considera- 
tions might easily disguise economic realities. 13 

The Transaction Basis 

Some propose to use the currency in which most transactions occur as 
the unit of account because this will simplify translation procedures. 
In fact, this reason was given by those nine Canadian companies 



12 Gerhard G. Mueller. International Accounting, p. 203. See also Xorlin Rueschhoff. 

International Accounting and Financial Reporting (New York: Praeger, 1976), pp. 

119-21. 

13 R. M. Skinner. Accounting Principles, A Canadian Viewpoint (Toronto: OCA. 

1972). p. 225. 



Unit of Account in MNE Financial Statements 27 



which account in U.S. dollars instead of Canadian dollars. 14 How- 
ever, a situation in which one currency dominates the business of a 
MNE so strongly is unlikely to occur, especially in times of fluc- 
tuating currencies. Usually this occurs in companies which operate 
in very few countries and where one country accounts for the over- 
whelming part of all operations. Furthermore, simplification of 
accounting procedures cannot be the only yardstick for sound 
accounting rules. 

The Ownership Basis 

Others argue that the currency in which the investor made his 
original investment should be used. This usually conforms with the 
currency in which dividends are paid. A close look shows two 
weaknesses of the argument. Because accounts are not usually 
adjusted for inflation, one does not really account in the currency in 
which the investor once made his investment. In fact, this will never 
be possible because investors buy stock at the market at different times 
and with different values of money. Also, reasoning associated with 
the "ownership basis" misinterprets the purpose of financial state- 
ments because one assumes a direct link between the investor and the 
amounts reported in the financial statements. But such a direct link is 
only created via the values of distributable profit and, to some extent, 
paid-in capital. All other data disclosed are primarily meant to 
inform about the state of the company (and not to show "links"). 
Therefore, it is correct to demand the translation of the amounts of 
distributable profit and paid-in capital into the currency which the 
"ownership basis" requires, but for all other items, the reasoning is 
irrelevant. 

None of these alternatives seems satisfactory. 

A NEW PROPOSAL: A DECISION-ORIENTED UNIT 

If we analyze the preceding points, we detect an obvious close 
relationship between the choice of the unit of account and the 
viewpoint from which we look at this problem. If we take the 
viewpoint of a domestic investor, we might require accounting in 
domestic currency. If we accept the viewpoint which would be 
expressed by a multitude of different multinational audiences, we 
might favor a local approach (financial statements expressed in local 



H These companies are INCO, Brascan, Seagrams, Hiram Walker. Canadian Inter- 
national Power Co., Alran, Asamera, Massey Fergueson, and Total Petroleum. See also 
Canadian Institute of Chartered Accountants. Financial Reporting in Canada, 11th 
edition (Toronto: CICA, 1975). p. 141. 



28 INTERNATIONAL JOURNAL OF ACCOUNTING 



currency). There also seem to be some differences in the degree of 
centralization of management's decision which might have an 
impact on the choice of the currency. 

Let us evaluate the last point first. The state of a company results 
from business decisions and their impact on the enterprise in its 
changing environment. Accounting provides a picture of the finan- 
cially measurable part of the state of the enterprise. Thus, accounting 
basically measures the impact of business decisions. Sound account- 
ing should measure decisions correctly, that is, the way decisions are 
made (its assumptions and intentions) should be as transparent 
through accounting as the result from these decisions. Accounting 
"reality" must conform with economic "reality" 15 or, since "reality" 
as such does not exist, with the perceptions concerning economic 
"reality" of those who are responsible for providing financial 
statements. This is mainly the responsibility of the company's 
management and, to some extent, the auditor who assures that 
management's perception of "reality" does not differ completely 
from what the auditor regards as "reality." 

Therefore, accounting must primarily reflect the perception of 
those who account. Unavoidably, management's evaluation of the 
company's state will assume a viewpoint which is also inherent in 
business decisions. In MNEs, different viewpoints can be found, 
depending on the basic organization of the decision-making process. 
If, for example, a MNE is very strictly organized in such a way that 
practically all of its decisions are made by the management of the 
parent company, this will imply that such decisions are often 
oriented towards the maximization of the parent company's earnings 
as expressed in domestic currency. Most decisions will then be made 
on the basis of the parent-company's currency, and consolidated 
accounts should reflect this basis. 

If, however, even major decisions are made in a decentralized 
manner, the viewpoint of quasi-independent subsidiaries, as ex- 
pressed in local results and in local currency, prevails. If we chose the 
parent company's currency under such a situation, we would 
incorrectly imply that this currency was the relevant basis for 
decision making in this MNE. A reader of financial statements would 



15 In the related area of translation of foreign accounts, a similar demand was brought 
forward by Burns when he pointed out that accounting exposure should correspond to 
economic exposure. See J. M. Burns, Accounting Standards and International Finance, 
•with Speiial Reference to Multinationals (Washington. D.C.: American Enterprise 
Institute for Public Policy Research, 1976), p. 1 1. 



Unit of Account in MNE Financial Statements 29 



be misled because he would expect decisions which aim specifically 
at maximizing the parent company's profits. 

This distinction, which pinpoints extreme situations, might 
appear theoretical with little practical importance. Nevertheless, it is 
precisely this distinction which has gained wide appreciation among 
both theoreticians and practitioners in a different area of research on 
multinational enterprises. We refer to Permutter's distinction of the 
types of MNEs according to the decision-making process 16 into the 
following. 

1. Ethnocentric Enterprises are strongly oriented toward domestic 
interests. This appears to be the first stage in the life of a MNE. Then 
management is still not aware of the problems that arise from 
differences in the economic environment a MNE faces. Among 
others, the ethnocentric approach implies — if we use American 
companies as an example — that American principles of doing 
business are enforced everywhere, no matter whether they fit or not. 

2. Polycentric Enterprises are strongly oriented toward local 
interests. This type exists during the second state of a MNE's life, 
when top management realizes, for example, that American business 
principles are not very useful in situations which are entirely dif- 
ferent from the American one. The result is a major effort to decen- 
tralize and manage the group "more akin to a confederation" 17 
giving each subsidiary a large degree of freedom. 

3. Geocentric Enterprises have adopted a global viewpoint, thus 
abstracting from local or domestic "national" interests. In this third 
and highest stage of a MNE's truly becoming "multinational," the 
group is regarded as "a whole whose focus is on world-wide objec- 
tives as well as local objectives, each part making its unique contri- 
bution with its unique competence." 18 This form is regarded as the 
most efficient, though also the most difficult to achieve, form of a 
MNE. 19 

How does this distinction relate to the unit of account problem? If 
we accept the fact that a decision leads to different accounting results 



16 H. Perlmutter, "Multinational Corporations," Columbia J ournal of World Business 
(1969): 12; and idem., "L'entreprise internationale, trois conceptions," Rei'ite eco- 
nomique et sociale (May 1965): 151. 
"Perlmutter, "Multinational Corporations," p. 12. 
18 Ibid. 

19 For example, A. W. Clausen (BankamericaCorp.) "The Internationalized Corpora- 
tion—An Executive's View," Annals of the American Academy of Political and Social 
Science (September 1972): 12; and J. Maisonrouge, "The Education of International 
Managers," Quarterly Journal of AISEC International (February 1967): 3. 



30 INTERNATIONAL JOURNAL OF ACCOUNTING 



if measured in different currencies, we must attempt to measure the 
impact of the decision in the currency in which the decision is made. 
The implicit currency of decision making seems different under each 
of these three situations. Theoretically, one must conclude that 
different currency mixes should be employed depending on the 
specific situation: very strict ethnocentric MNEs in which all but very 
minor decisions are made by the parent company's management 
should use the domestic currency. Such a situation is likely to occur if 
the company has only minor operations abroad (for example, 5 
percent of its activities). However, as soon as the international 
division assumes a larger share of the company's activities, such an 
ethnocentric approach will unavoidably be "watered down" since a 
certain amount of "going native" will be inevitable. As a conse- 
quence, the majority of decisions will still reflect a domestic view- 
point (as expressed in domestic currency) but will also include con- 
siderations of foreign local implications. In this case, a currency mix 
which is weighted in favor of the domestic currency would be 
appropriate. 

The unit of account of a polycentric MNE should, on the other 
hand, reflect the multiplicity of currencies that underlie business 
decisions. To obtain an adequate unit of account for the group as a 
whole, one would have to create a currency basket which reflects 
adequately the importance of the local decisions for the group as a 
whole. As a yardstick, one could try to measure the relative importance 
of a subsidiary for the group as a whole. Through this a weighting 
factor can be derived for determining the share of this currency in the 
group's unit-of-account basket. Since decision making in the geo- 
centric MNE is not based on purely local or domestic considerations, 
such a company-specific basket of currencies is unnecessary. Instead, 
the counterpart to multinational decision making is a multinational 
unit of account. 

Can these considerations be applied to actual situations in MNE 
activities? The author does not believe the proposals for ethno- and 
polycentric MNEs can be used in practice. Certainly, it would be 
almost impossible to find adequate criteria to choose the weighting 
factor of each currency in the mix. Would sales volume of the 
subsidiaries, assets, equity (or net exposure), number of employees, 
profitability, or company outlook be correct factors? How could such 
criteria be linked together? 

Also, such a basis must be redefined annually because not all 
subsidiaries perform the same way. Thus, consistency in financial 
statements would be difficult to maintain. Finally, there would be too 



Unit of Account in MNE Financial Statements 31 



many opportunities for manipulation on such a basis. The reliability 
of published data could suffer considerably. 

Similar problems are not present if we follow the alternative 
suggested for the geocentric MNE. Here one can abstract from 
company-specific criteria and can thus avoid questions of weighting 
factors and manipulation. Several such international currencies have 
been discussed and used in recent years, such as the European Corn- 
posit Unit, Special Drawing Rights (SDRs), 20 and, recently, the 
European Currency Unit. Only the SDRs, however, have gained 
international acceptance. 

A major advantage of SDRs is their reliability. Since they are fixed 
by an independent intergovernmental authority, they leave little if 
any leeway for manipulation. They are as good as any given currency 
in this respect. 

SHOULD MNEs ACCOUNT IN TERMS OF SPECIAL DRAWING RIGHTS? 

We think that the answer must be affirmative. Although it might be 
theoretically possible to distinguish between ethno-, poly- or geo- 
centric MNEs, we must agree to the fact that it will be impossible to 
distinguish clearly enough between these types. Such situations 
evolve gradually, and any separation would necessarily be too 
arbitrary to be useful. What we therefore need is a unit of account 
which is somewhat acceptable under each "multinational" circum- 
stance. As the other alternatives of currency mixes seem impracticable, 
only the choice between the domestic currency and the SDR as a unit 
of account in consolidated statements exists. But while the domestic 
currency is an appropriate unit only under very specific circum- 
stances (if a MNE is very ethnocentrically oriented), SDRs are correct 
for one kind of MNE (the geocentric) and are at least not totally 
incorrect for both of the other types, as both theoretically require 
some form of currency mix. 

The example of revaluations/devaluations, as related to SDRs, 
demonstrates another very important point. To date, accounting 
theory in the field of foreign exchange has always assumed implicitly 
that changes in exchange rates are due to factors which influence 
foreign currencies, while the unit of account remains stable. We 
assumed that the deutsche mark and the French franc were respon- 
sible for exchange-rate changes in relation to the Swiss franc. This 
may or may not be true. But if a speculative action is directed against 
the unit of account, for example, the Swiss franc, this completely 

20 See Appendix. 



32 INTERNATIONAL JOURNAL OF ACCOUNTING 



distorts the picture of financial statements denominated in that 
currency. 

Such changes in the so-called "external value" of the unit of 
account have thus far escaped the attention of accounting theory 
while changes in the "internal value" of this unit, inflation, have 
dominated accounting theory during the last decade. It is now 
appropriate to think of changes in the external value of a unit of 
account as well. Unfortunately, we cannot rely on a close relationship 
between the external and internal value of a currency as the 
purchasing-power parity theorem assumes. Even over extended 
periods, this theorem does not hold well enough. 21 Therefore, only by 
separately accounting for changes both in the external and the 
internal value of a currency can accounts of a MNE become 
meaningful. 

The use of Special Drawing Rights might help in solving this 
problem. Although they were not designed in a way that would keep 
them entirely unaffected from revaluations/devaluations of the basket 
currencies, they lessen the impact of changes in the external value of 
any basket currency considerably. After all, there are no speculative 
actions "against SDRs." 

We therefore conclude that the SDR should be the unit of account 
for consolidated statements of MNEs. To show the impact of such a 
unit of account, the earlier examples have been translated into SDRs 
("X") as well. The author believes that the resulting accounting 
statements are the most adequate ones for measuring the activities of a 
MNE. 

THE RESULTS MAY BE ADEQUATE, BUT ARE THEY UNDERSTANDABLE? 

One final question remains to be answered. Most readers of financial 
statements are unaware of what SDRs are, how they are calculated, 
and how they evolve. Would it be advisable, therefore, to translate 
accounts which are denominated in SDRs into the respective local 
currencies? The answer must be found by reviewing the two cases 
given earlier. There could be little objection to translating the 
statements of one period at a uniform exchange rate into another 
currency. In this case, all ratios would remain unchanged. 

Problems arise, however, with the second case. If we translate 
amounts denominated in SDRs into Swiss francs, for example, we 



21 For the period 1955 to 1975 (1970 to 1975), we calculated an arithmetic average of the 
deviation between inflation rates and exchange rates of twenty-nine countries of 15.6 
percent (27 percent). The absolute average of the deviation was even 34.2 percent (29.3 
percent). See Jacobi. "Probleme," p. 17fi. 



Unit of Account in MNE Financial Statements 33 



shall again come to the same incorrect results in trend analysis as if we 
translated these amounts directly into Swiss francs. Again, we would 
have results which reflect, to a large extent, changes in the external 
value of the "reporting" unit of account (the Swiss franc). Trend 
analysis again would yield results which do not match the underlying 
economic situation, and the analysis of accounting performance over 
an extended period would differ materially from the economic per- 
formance over this period. 

These problems appear to be so formidable that the author believes 
that they prohibit a translation of SDR statements into local currency 
units. Providing the annual statements in local currency (case 1) and 
explaining trends on the basis of SDRs (case 2) also do not appear 
desirable because the use of two units of account in one report will 
only add to confusion. 

In this situation, we have a choice between two evils: publishing 
easy to understand but incorrect accounts or providing a correct 
picture of the company's state which needs some explanation. If the 
most important aim of accounting is to provide a "true and fair view" 
of the state of the company, we must accept the "second evil" and take 
the burden of explaining the unit of account. SDRs are not the first 
new issue which is introduced into accounting and needs some 
explanation in the beginning. After a few years, however, interested 
parties which really want to evaluate the MNE carefully will already 
understand what SDRs are. 

The only meaningful exceptions to this reporting in SDRs might 
be the distributable profits and paid-in capital of the parent company. 
Since both are legally denominated and payable in a given currency, 
it seems reasonable to translate the respective amounts into this 
currency and disclose them in the footnotes. These two items are the 
only direct links between the investor and the company in which he 
invested. All other data are published only so that a reader of financial 
statements is able to judge the state of the company correctly. 

If separate statements of the parent company are published as 
well — this is common practice in most countries except in the United 
States and Canada — even the translation of these two amounts could 
be avoided since both would appear in the parent-company's state- 
ments which would (correctly) be denominated in domestic currency 
units. This approach to disclose parent-company statements as well 
probably is superior to merely translating paid-in capital and profit, 
because additional evidence on the situation of the parent company 
would be provided. 



34 INTERNATIONAL JOURNAL OF ACCOUNTING 



APPENDIX 

SDRs were created by the International Monetary Fund. They are 
only a unit of calculation, not a currency of their own. They are a 
measurement basis for transactions between federal reserve banks of 
different countries. For several years, however, they have gained some 
acceptance in the private sector, where they are used as a denominator 
of international contracts — they are employed as a means to hedge 
against currency fluctuations — and in the Eurobond business. In 
these cases, a certain amount (to be paid/received) is fixed in SDRs 
but is payable in any convertible currency according to the exchange 
rate for SDRs at due date. 

SDRs are calculated on the basis of a fixed currency basket which 
consists of sixteen currencies. The share of each currency is determined 
according to the share of world trade of that country (U.S. dollars 
counting twice). Today, the basket is defined as consisting of 33 
percent U.S. dollar + 12.5 percent deutsche mark + 7.5 percent 
Japanese yen + 7.5 percent French franc + 7.5 percent pound sterling + 
5 percent Italian lira + 5 percent Dutch guilder + 5 percent Canadian 
dollar + 4 percent Belgian franc + 3 percent Saudi rial + 2 percent 
Swedish crown + 2 percent Iranian rial + 1.5 percent Australian dollar 
+ 1.5 percent Spanish peseta + 1.5 Norwegian crown + 1.5 percent 
Austrian schilling. To calculate the value of one unit of a SDR at a 
given date, all parts of the basket are translated into U.S. dollars 
according to the prevailing exchange rates and then weighted accord- 
ing to the respective percentages. Thus, via the U.S. dollar exchange 
rates, one can determine the value of a unit of SDR in any currency. 

If the exchange rate of one of the basket currencies of the SDRs 
changes, the value of the SDRs changes too, although less dramatically. 
If, for example, the deutsche mark appreciates by 10 percent as 
compared with any other currency, the value of SDR increases by 10 
percent of 12.5 percent that is, 1.25 percent. So, the SDR "devalues" 
compared with the deutsche mark but "revalues" compared with all 
other currencies. 






An Analysis of Corporate Social Reporting in 
Germany 

BIKKI JAGGI* 



In the early 1970s, academicians and practitioners began to focus 
attention on corporate social reporting, suggesting several models for 
this. These included Linowes' Socio-Economic Operating State- 
ment, 1 Seidler's Social Income Statement, 2 and Estes' Social Cost 
Benefit Analysis Statement. 3 Abt Associates, a consulting firm, 
achieved a pioneer accomplishment by publishing a comprehensive 
social balance sheet and income statement. 4 These statements at- 
tempted to report the social impact of corporate activities. The Scovill 
Manufacturing Company also endeavored to categorize firm activities 
according to social assets and social liabilities and published a social 
action report. 5 

This early enthusiasm for corporate social reporting, however, was 
not widespread and did not inspire management in general to dis- 
close social information. Few firms followed Abt's lead in disclosing 
social information in a systematic form. Although Ernst and Ernst's 6 



•Bikki Jaggi is associate professor at the School of Management, State University of 

New York at Binghamton. The author is grateful to Professor Kenneth S. Most for his 

helpful comments and suggestions. 

l D. F. Linowes, The Corporate Conscience (New York: Hawthorne Books, 1974). 

2 L. J. Seidler, "Dollar Values in the Social Income Statement," in L. J. Seidler and L. L. 

Seidler. editors, Social Accounting: Theory, Issues and Cases (Los Angeles: Melville 

Publishing, 1975). 

3 R. W. Estes, "A Comprehensive Corporate Social Reporting Model," reproduced in 

Seidler and Seidler, Social Accounting. 

'■Annual Reports of Abt Associates, Inc. 

M972 Annual Report of Scoville Manufacturing Company. 

6 Ernst and Ernst, Social Responsibility Disclosures (Cleveland: Ernst and Ernst, 1971- 

77). 



36 INTERNATIONAL JOURNAL OF ACCOUNTING 



survey of annual reports indicated that, in general, the number of 
firms disclosing social information in some form has increased 
steadily, it is evident from the result of this survey that these dis- 
closures do not follow any pattern; social accounting information 
appears in different forms and in different locations in annual 
reports. 

Corporate social disclosure practices in European countries, 
especially Germany, reveal a different trend than those in the United 
States. In the early 1970s, social disclosures did not receive much 
attention. These disclosures only recently began to receive greater 
importance in corporate annual reports. 7 The number of German 
firms disclosing social information as an integral part of their annual 
reports is steadily increasing. 8 Furthermore, a pattern for social 
disclosures is emerging. Shell's German subsidiary, Deutsche Shell 
A.G., is becoming a model for social disclosures for many firms. 

This paper analyzes Deutsche Shell's social disclosure model. The 
concepts of a social accounts statement and a value-added statement 
receive special scrutiny. This paper should allow readers to learn of 
the actual experience of Germany in the preparation and publication 
of social reports and related social statements. The paper may also 
stimulate researchers and managements to evaluate critically social 
disclosure concepts developed in Germany and to examine whether 
these could be modified to suit the needs of firms in other countries. 
This paper is based not on abstract ideas relating to social disclosures 
but on pragmatic approaches to the feasibility and desirability of 
social disclosures. 

STRUCTURE OF SOCIAL REPORTS 

The social reporting structure in Germany has been experiencing a 
steady change. This reporting began with a narrative description of a 
firm's activities which had social impact. Later, the narrative descrip- 
tion was modified to include a comparison of expenditures on social 
activities with social benefits accruing from the firm's activities. Since 
the quantification of social benefits was not possible, the description 
of benefits was narrative. Several German firms have used this model 
of social reporting. The social reports of STEAG and Saarbergwerke 
A.G. are early classic examples of this type of social reporting. In 



'Social disclosures are being mandated in France. 

8 The number of German firms reporting social information in a systematic form has 
increased to 12. Most large publicly held corporations are in the process of including 
social disclosures in annual reports in some form. 






Corporate Social Reporting in Germany 37 



1975, both BASF and Pieroth Vineyard Company also published 
similar social reports. 

Recently, a new format for social reports has been developed, and 
this is being followed by most German firms which disclose social 
information. The social report is an integral part of the annual 
report. The first part of the annual report contains a description of the 
firm's economic and social goals and highlights the firm's activities 
in pursuit of these goals. Where possible, the description of these 
activities is supported by data and graphs. The discussion contained 
in part one provides information on management philosophy and 
the approach of management to social problems and issues. The 
second part of the annual report is comprised of five statements. In 
addition to the traditional statements, the balance sheet, income 
statement, and statement of changes in financial position, this section 
contains a social accounts statement and a value-added statement. 
The latter two have been added to provide additional specific infor- 
mation on the social impact of corporate activities. Both of these 
statements and the description of the firm's goals are discussed in this 
paper with special reference to Deutsche Shell's annual report. 

GOAL ORIENTATION IN CORPORATE ANNUAL REPORTS 

Deutsche Shell's management realized that changes in the social 
environment require a collateral change in the goals of the firm. In 
addition to achieving a reasonable return on investment, the firm 
recognized the need for other goals. The following goals received 
special emphasis in the report, beginning with 1975: 

1. Achievement of an adequate return on investment; 

2. Meeting consumers' needs as determined by market conditions; 

3. Development of new processes and products; 

4. Consideration of employees' interest; and 

5. Regard for public concerns. 

Each of these major goals is divided into subgoals. The first part of 
the annual report contains a discussion of the subgoals and the firm's 
important activities in pursuit of them. Although the major portion 
of the activities' description is narrative, the discussion is extensive 
and centers on specific objectives. This discussion covers approxi- 
mately fifty-seven pages of the 1977 report. Highlights of the first 
section of Deutsche Shell's 1977 annual report are summarized here. 

The discussion on the objective of return on investment provides a 
summary of financial results for the 1968 to 1977 period, including a 



38 INTERNATIONAL JOIRNAI. OF ACCOUNTING 



summary of the performance of its subsidiaries. The report also 
discusses the firm's policy to secure an adequate return on investment. 
The section on consumers' needs comments on improvements in 
product safety and quality. The main emphasis, however, is on 
pricing policies and analysis of sales by product line, production, and 
exploration. In addition, comments are offered on the company's 
competitive position, tanker and chemical business, market research, 
exploration, and diversification. The discussion of goals for develop- 
ment of new products and processes deals with research and develop- 
ment issues which could save energy, reduce costs, improve the 
environment, and assure users' health and safety. 

The goal relating to the consideration of employees' interest is 
especially emphasized and receives more coverage than other goals. It 
describes the firm's personnel structure in terms of age and sex, 
employee training programs and associated costs, on-the-job acci- 
dents, expenditures on employee health plans, employee motivation, 
and reasons given by employees for leaving the firm. 

The discussion of subgoals relating to public concerns provides 
information on the influence and interaction between the firm and 
(1) its natural environment, (2) the government, (3) economic/ 
society science, (4) people, (5) youth, and (6) workers belonging to 
disadvantaged groups. This section also reports expenditure figures 
on investments relating to the improvement of the physical environ- 
ment, such as air and water purification projects. 

The inclusion of goals of the firm in social reports has received 
great attention in Germany, and firms there are in the process of 
including this information in their annual reports. Critics, however, 
question the usefulness of goal orientation of annual reports. The 
criticism primarily relates to the general statement on management 
philosophy and corporate goals. It is argued that a firm's social 
performance can be measured only in terms of specific goals, such as 
the reduction of pollution to a certain level. Therefore, it is suggested 
that a description of the firm's goals in general is also useful to the 
extent that it provides information on management philosophy and 
approach. The description explains why certain of the firm's activ- 
ities are undertaken by management, and enables readers to judge 
whether these activities are really directed toward the goals. Further- 
more, the inclusion of a description of the firm's goals in its annual 
statements is likely to encourage management to direct the firm's 
activities in a particular direction. In the absence of established social 
goals, management philosophy and managerial policies will remain 
obscure. 



Corporate Social Reporting in Germany 39 



SOCIAL ACCOUNTS STATEMENT IN SOCIAL REPORT 

The narrative description of enterprise goals, however, is not the most 
important development in German social reporting practices. This 
approach was employed by some U.S. firms in the early 1970s (for 
example, the Bank of America's Social Program Management and 
Quaker Oats' 1973 Social Progress Plan). The important contribu- 
tion of this recent social reporting effort by German firms is the 
preparation of the Sozialrechnung (social accounts statement) and 
Wertschoepfungsrechnung (value-added statement). These statements 
attempt to present the firm's social performance in the perspective of 
an interaction of corporate goals and interests of the firm's 
constituencies. 

The social accounts statement was first developed in 1972 by 
STEAG, a mining company. It has now become an important state- 
ment for social disclosures by almost all German companies pro- 
ducing social reports. The objective of this statement is to report 
activities which impact on important constituencies of the firm. 
Deutsche Shell considers the following as important constituencies: 
employees, investors (financiers), community, and the firm itself in 
terms of capital maintenance. The community constituency can be 
further divided into such categories as government, the physical 
environment, and the social environment. 

The information contained in the social accounts statement is 
primarily obtained from the income statement. However, some items 
are presented in greater detail, so as to provide more information than 
that which would be available from the income statement alone. The 
social accounts statement from Deutsche Shell's 1977 annual report is 
reproduced in exhibit 1. 

The objective of the social accounts statement appears to be to 
highlight the firm's activities in relation to its constituencies. The 
employees' constituency received special emphasis. The items in each 
section are referenced to the narrative section of the report on corpor- 
ate goals and also to the income statement. This statement goes 
beyond the traditional narrow presentation of financial analysis 
related to the profitability and liquidity of the firm. It states expendi- 
ture items in terms of their purpose. The primary source of 
information, however, is the income statement. In addition to the 
reorganization of available information, the statement does not pro- 
vide additional information; it merely emphasizes the firm's costs 
related to employees and other constituent groups. Thus, it can be 
argued that presentation of detailed cost information is not likely to 



40 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 1. Deutsche Shell's Social Accounts Statement* 



I. Firm and employees 




Report 
page 


Income 

statement 

position 


Cost (000 DM) 




1977 


1976 


1. Wages 
Salaries 


37 

37 


16 
16&26 


68,087 
146,153 
214,240 


64,392 
138,054 
202,446 



Benefits accruing directly to employees 
now working in the firm 

(a) Christmas bonuses & gifts 

(b) Vacation pay 

(c) Contributions to savings plans 

(d) Others (rebates, etc.) 

(e) Premiums for improvement — 
suggestions 

(f) Bonuses for work anniversaries 
(g) Special recognition of birth 

(h) Special recognition of marriage 
(i) Rent subsidies Travel grants 
(j) Premiums resulting from 

competitions 
(k) Firm's 75th anniversary 





16 


17,693 


16,153 




16 


6,539 


6,154 




16 


3,021 


3,042 




1,18.26 


1,208 


1,146 


42 


16 


141 


106 




16 


528 


550 




18 


26 


28 




18 


144 


157 




16 & 26 


639 


604 


39 


16 


604 


532 


37 


16 & 26 


13,776 


— 



44,319 28,472 



Benefits accruing directly to employees 
who are no longer with the firm 

(a) Pension payments 40 

(b) Christmas bonuses & gifts 40 

(c) Firm's 75th anniversary 37 



18 



5. Benefits accruing to employees collectively 

(a) Education and training 34-36 Misc. 

(b) Accident prevention 38/39 Misc. 

(c) Company medical services 39/40 Misc. 

(d) Employee information service 43 Misc. 

(e) Lunches and hot drinks 41 Misc. 

(f) Vacation homes 41 Misc. 

(g) Subsidies to sport associations 41 

(h) Work clothes 26 



32.366 


30,068 


942 


965 


3,072 


— 



36,380 



31,033 



Benefits accruing indirectly to employees 

(a) Employer's contribution to 
pension, health and unemploy- 
ment insurance 1 4 8c 17 

(b) Contributions to trade unions 17 

(c) Costs for company health plans 41 Misc. 

(d) Insolvency insurance 

inheritance tax insurance 18 

(e) Payments for pension reserves 18 



24,960 


23,302 


1,936 


1,866 


708 


651 


1,089 


941 


57,559 


52,312 


86,252 


79,072 


3,455 


3,153 


2,500 


2,500 


958 


941 


321 


287 


4,007 


3,786 


100 


88 


496 


496 


733 


677 



Corporate Social Reporting in Germany 41 





Exhibit 1. (cont.) 




I. Firm and employees 




Income 

Report statement 

page position 


Cost (000 DM) 




1977 1976 



(i) Counselling 44 

(j) Election costs to board of direc- 
tors (employees' representatives) 43/44 



Misc. 



1,744 

57_ 

14,371 



1.594 



13,522 



TOTAL I 

Less double counting 

(Labor Costs and Depreciation) 



395.562 354,545 

(7,247) (6,432) 

3.315 348,113 



II. Firm and investors 


Cost (000 DM) 
1977 1976 


1. Dividends 

2. Bonus 

3. Interest costs 






48,228 


190,000 

100,000 

48,861 


TOTAL II 






48,228 


388,861 


III. Firm and community 




Report 
page 


Income 

statement 
position 


Cost (000 DM) 




1977 


1976 



I. Firm and government 

(a) Taxes and levies 
EEV-taxes 
Other taxes 
LAG 

Promotion levy for German 

oil and gas 

Utilized reserves for taxes 

Not paid, but recorded 

Tax liabilities from prior years 

(b) General and special fees 

(c) Receipts (subsidies investment 
credits credits) 



50 


24a 


46,834 


125,698 


50 


24 b 


1,046 


297 




24c 


— 


7,043 


50 


5 


89.251 


61.693 






1,287 


1,313 




14 


(5,484) 


(8,509) 




132,934 


187.535 




26 


6.406 


5.790 


28 


14 & 26 


(622)** 


(29.446) 



2. Firm and public 

(a) Subscription to associations 
and institutes 

(b) Grants 

(c) Youth work 

(d) Publications, etc. 

(e) TS-partner-training 



51 


26 


4.509 


4.370 


51 


26 


829 


563 


52 53 


Misc. 


800 


770 


50-53 


Misc. 


1,924 


1,264 


36 


Misc. 


2,213 


2.453 



10,275 



9.420 



42 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 1. (cont.) 




III. Firm and community 


Report 
page 


Income 
statement 
position 


Cost (000 DM) 


1977 1976 


3. Firm and physical environment 
Expenditures for safety of 
environment 48 


Misc. 


60.800 54,100 



TOTAL III 

Less double counting 

(Labor cost and depreciation) 



209.793 227.399 



(21.005) 
188,788 



(17.304) 
210,095 



I\ 


Firm and phvsical capital maintenance strengthening 








Cost (000 DMi 




1977 1976 



1. Cost for research and development 30-32 Misc. 

2. Capital maintenance (depreciation) 19 

3. Development of reserves 30 8c 31 

4. Profit loss carried forward 11 29 



19.700 16,400 
233.809 274,609 
— (49,617) 
(34,568) (J9}_ 



TOTAL IV 

Less double counting 

(Labor costs and depreciation) 



218,941 

(10,967) 
207,974 



241.373 

(8,945) 
232,428 



•Author's translation from annual report. 

••This includes adjustments for investment credits for tanker "Lottia. 



provide a suitable basis for the evaluation of the firm's social per- 
formance. The statement is useful, however, to the extent that it 
provides detailed information on the firm's activities relating to 
employee welfare, and might also facilitate comparative analysis of 
the firm's activities for employees in relation to other contituencies. 

VALUE-ADDED STATEMENT IN SOCIAL REPORT 

The value-added statement is another important addition to tradi- 
tional statements. The primary objective of this statement is to 
highlight the firm's contribution to society determined on the basis of 
value increment. This statement also reports the distribution of 
value-added amounts to various constituencies. 

The value-added statement consists of two parts. Part one is based 
on the value generation process and describes sources of value to the 
firm. These sources include sales revenue, changes in inventory, and 
self-constructed assets. From the total revenues, the material costs, 
depreciation, and other costs paid to outsiders are deducted. The 






Corporate Social Reporting in Germany 43 



second section is based on the value distribution process and describes 
how values created in the firm are distributed to the firm's various 
constituencies. Information contained in this statement is obtained 
from social accounts statements and traditional financial statements. 
Deutsche Shell has expanded the value-added statement to include 
details on the firm's performance. This is done to reconcile the social 
accounts statement with the financial statements. Deutsche Shell's 
performance value-added statement from the 1977 annual report is 
reproduced in exhibit 2. 

Part one of the statement describes gross and net performance. In 
part two, distribution of performance to four constituencies is shown. 
The performance statement is connected with the value-added state- 
ment by adjusting depreciation and performance from the preceding 
periods. 

Exhibit 2. Deutsche Shell's — Performance — Value-added Statement* 



Source of performance 



Income 
statement 
position 



1977 



1976 



(000 DM) 


(000 DM) 


8,348,446 


8,724,346 


91,240 


84,811 


5,358 


4,506 


59,136 


161.368 


1,107 


897 


4,665 


3,337 


6,578 


11,633 


1,756 


4,771 


676 


403 



Sales proceeds 1 

Changes in inventories 2 

Other capitalized company-produced 

assets 3 

Income from profit-carrying contracts 7 

Income from investment participation 

in other firms 8 

Income from other financial investments 9 

Interest income 10 

Income from assets reductions 1 1 

Income from reductions in values 12 

Income from dissolving reserves and 

other positions related to reserves 13 

Other income 14 



1,723 
281,794 



12,334 
271,171 



Firm's performance 



8,802,479 



9,279,517 



Costs for direct and indirect materials 

Depreciation and changes in financial 

investments 

Loss from reductions in current assets 

Loss from reductions in plant 

& equipment 

Costs from assumption of losses 

Adjustment in special positions 



5 


(6,884,848) 


(7,058,923) 


20 
21 


(52,312) 

(5,968) 


(41,083) 
(3,100) 


22 
25 


(5,498) 
(30,910) 


(7,297) 
(26,998) 



related to reserves 
Other costs 


25a 
26 


(1,087) 
(988,561) 


(5,530) 
(995,482) 


Net performance 




833,305 


1.141.164 


(11,667)** 



44 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 2. (cont.) 



Performance for 


1977 
(000 DM) 


Or 

/o 


1976 
(000 DM) 


% 


Employees 
Investors 
Community 
Firm 


388,315 

48,228 

188,788 

207,974 


46.6 

5.8 

22.7 

24.9 


348,113 
338,861 
210,095 

232,428 


30.8 
30.0 
18.6 
20.6 


Distribution of performance 


833,305 


100.0 


1,129,497 


100.0 


Connection with the value-added statement 


1977 
(000 DM) 


Of 


7976 
(000 DM) 


/Q 


Separation of earlier performance 
from performance distribution 

From depreciation 

Other earlier performances 


(233,809) 
(161,211) 




(274,609) 
(93,634) 




Value-added 


438,285 




761,254 




Distribution of value-added to 
Employees 
Investors 
Community 
Firm (reinvestment) 


376,745 
48,228 
47,880 

(34,568) 


86.0 

11.0 

10.9 

7.9 


338,991 
338,861 
133,038 
(49,636) 


44.5 
44.5 
17.5 

(6.5) 




438,285 


100.0 


761,254 


100.0 



•Author's translation from annual report. 

"Subsidy from government, not included in the income statement. 



The usefulness of the value-added statement has been questioned in 
German accounting literature. As previously explained, the state- 
ment primarily restructures financial statement items and highlights 
sources for value creation and distribution of created value to differ- 
ent constituent groups. It has been argued that this statement does 
nothing more than show a firm's contribution to the GNP. Though 
this statement is receiving greater attention in Germany, its useful- 
ness in reporting and explaining the firm's social performance 
evaluation is limited. 



CONCLUSION 

Although social reporting in Germany today is still not as compre- 
hensive as Abt's social balance sheet and income statement of 1975, it 
is unique in its structure. Social accounting disclosures by German 
firms have become an integral part of German corporate annual 
reports. They contain detailed information on the firm's economic 
and social goals. The statement of social accounts and the value- 
added statement present comparative information on the firm's 
financial interaction with important constituencies. 



Corporate Social Reporting in Germany 45 



The firm's activities in relation to the employee constituency, 
however, receive special attention in these disclosures. This emphasis 
on employee relations may be due to the following reasons. The state 
of the art on the reporting in this area is probably more advanced for 
other social accounting areas. Furthermore, the business-political 
environment in Germany may have influenced this reporting. Worker 
participation in corporate decision making (Mitbestimmung) is a 
widely accepted phenomenon, and unions play an important role in 
this process. 

Physical and social environmental issues have not attracted much 
attention in the social accounting disclosures in Germany. These 
issues are discussed mainly by disclosing actual expenditures relating 
to the abatement of pollution and social contributions. Although the 
objective of Deutsche Shell's statement has been to report the social 
impact of the firm's activities, it has failed to do so. Social costs and 
benefits resulting from activities have not been presented in the 
statement, and the negative impact of the firm's activities has been 
ignored. These issues have probably been omitted on the grounds of 
practicality. The usefulness of social information will remain limited, 
however, unless suitable methods to quantify and present social 
impact are developed. 

Despite this criticism, the social reports currently published by 
German firms represent progress in the development of social ac- 
counting disclosures. The experience of German firms may have an 
impact on social accounting disclosures in other European countries. 
The concepts developed in Germany may be modified and refined to 
suit the environment of other countries. The German social dis- 
closure practices also need to be evaluated critically to help in the 
development of an optional disclosure format in other countries. 



A Cross-Sectional Analysis of Qualified Audit Reports 



MICHAEL FIRTH* 

The two major types of audit qualification encountered in the United 
Kingdom are those relating to noncompliance with Statements of 
Standard Accounting Practice (SSAPs) and those relating to uncer- 
tainties. Companies are expected to adopt SSAPs in preparing their 
annual accounts and if they do not, the auditor is then required to 
qualify the audit report. Uncertainty qualifications arise when the 
auditor has some doubt regarding, for example, whether a firm can be 
regarded as a going concern or has some doubts on the valuation of 
assets. 

Recently there has been a substantial increase in audit qualifi- 
cations in the United Kingdom. Three major reasons for this growth 
are the following. 

1. The growing number of SSAPs in issue. 1 This, of course, increases 
the chances of a company not complying with at least one SSAP and 
thus receiving an audit qualification. Additionally, company finance 
directors have increasingly criticized the restrictive nature of SSAPs, 
and this has also contributed to the number of cases of noncompli- 
ance. 

2. The financial and economic crises of the mid-1970s, which re- 
sulted in many companies facing significant liquidity and profit- 
ability problems. This situation, in turn, resulted in an increase in 
audit qualifications for going-concern reasons and for asset valuation 
reasons. 



•Michael Firth is professor of accountancy at Victoria University of Wellington. New 
Zealand. The author wishes to thank anonymous referees for their helpful comments 
on an earlier draft of the paper. 
'The first SSAP was issued in 1971; at present there are 14 in issue. 



48 INTERNATIONAL JOURNAL OF ACCOUNTING 



3. The increased publicity that has been given to firms that have 
become bankrupt even though possessing clean audit reports. For 
example, many auditors have received criticism from Department of 
Trade inspectors investigating the sudden collapse of major stock 
market-quoted companies, and these have been widely reported in the 
news media. 2 This adverse publicity and the growing concern over 
possible legal actions may have led the auditing profession to be more 
cautious, and thus more qualified reports may have resulted. 

The purpose of the paper is to report the results of a research project 
which investigated the existence of common features relating to 
companies receiving audit qualifications which differentiated them 
from companies which did not receive qualified audit reports. Such 
an analysis may help us to examine some of the hypotheses that can 
and have been suggested to explain the occurrence of audit qualifica- 
tions in the recent past. This, in turn, may be helpful to users of 
accounts who must evaluate the impact of an audit qualification in 
their decision making. If any strong associations are found between 
the occurrence of audit qualifications and some financial feature(s), 
this might help us to predict future audit qualifications. 

The research design uses a cross-sectional analysis approach in 
determining whether there are any common features (such as the firm 
of auditors involved, size, industry, earnings performance, and share- 
price performance) which differentiated companies who received 
audit qualifications from those who received clean audit reports. The 
empirical examination used audit qualifications appearing in 1976, a 
year of peak activity. 

The results of the study are compared with those of similar research 
conducted in the United States. Warren made a cross-sectional study 
of uncertainty qualifications reported in the first four months of 1973 
in which he addressed the question of the uniformity of auditing 
standards. 3 A number of other studies 4 have analyzed the characteris- 



2 I. H. Davison, "The Future of Auditing Is in Our Own Hands." Accountancy (July 
1977). 

3 C. S. Warren, "Uniformity of Auditing Standards," Journal of Accounting Research 
(Spring 1975). 

4 W. G. Bremser. "The Earnings Characteristics of Firms Reporting Discretionary 
Accounting Changes," Accounting Review (July 1975); B. E. Cushing and E. B. 
Deakin, "Firms Making Accounting Changes: A Comment," Accounting Reinew 
(January 1974); M. L. Gosman, "Characteristics of Firms Making Accounting 
Changes," Accounting Reinew (January 1973); idem., "Firms Making Accounting 
Changes: A Reply," Accounting Review (January 1974); Warren, "Auditing Stan- 
dards"; and idem.. "Characteristics of Firms Reporting Consistency Exceptions — A 
Cross-Sectional Analysis," Accounting Review (January 1977). 



Cross-Sectional Analysis of Audit Reports 49 



tics of firms receiving consistency qualifications. These qualifica- 
tions relate to changes in accounting methods made by companies 
from the previous year. 

The next section of the paper discusses some hypotheses that have 
been used to explain the occurrence of audit qualifications. The next 
section also suggests financial characteristics which may help us to 
assess the validity of these hypotheses in explaining audit qualifica- 
tions in 1976. 

HYPOTHESES CONCERNING REASONS COMPANIES 
RECEIVE AUDIT QUALIFICATIONS 

Companies do not like to receive qualified audit reports and the 
adverse publicity this brings them. Additionally, it has been shown 
that uncertainty-qualified audit reports have a distinctly negative 
impact on investors and bankers, although the evidence relating to 
SSAP qualifications indicates a much lesser effect. 5 It is not unusual, 
therefore, to find that companies will expend much effort to satisfy 
the auditors' doubts. Despite these efforts, audit qualifications do 
appear, and most are unavoidable (for instance, uncertainty qualifi- 
cations where the firm cannot satisfy the auditors' doubts no matter 
how much effort is spent), although some are avoidable (mainly 
SSAP qualifications). Hypotheses relating to why some companies 
received qualifications while others did not will be presented. 

SSAP Qualifications 

1. The usual reason given by companies for not complying with a 
particular SSAP is that to do so would result in the annual accounts 
showing an erroneous view. These companies would prefer to use 
what in their opinion is a better accounting practice and to incur the 
audit qualification. SSAPs have been developed with the average 
company in mind, and no exceptions are granted for specific in- 
dustries or circumstances. Thus, if a specific SSAP is not relevant for a 
particular industry, we might expect to see a large number of firms 
within that industry receiving qualified audit reports. SSAP qualifi- 
cations may also be associated with delays in the publication of the 
annual accounts; this represents the time spent attempting to resolve 
differences between the client company and the auditor. 

2. Another possible reason for noncompliance with an SSAP is that 
the alternative accounting treatment being used may result in a better 



5 M. A. Firth, "Qualified Audit Reports: Their Impart on Investment Decisions," 
Accounting Remew (July 1978); and idem.. "Qualified Audit Reports and Bank 
Lending Decisions," Journal of Bank Research (Winter 1979). 



50 INTERNATIONAL JOURNAL OF ACCOUNTING 



picture of the company's position (for example, it may show higher 
profits or reduced losses). Since there may be many reasons for a 
company wanting to show a better picture (even if only temporary), 
the company may be willing to trade off the negative impact of an 
audit qualification for the "benefits" which they perceive will flow 
from showing a higher level of profits, for instance. Given that most 
SSAP qualifications show profits as being too high under the alterna- 
tive accounting treatment used, this reason is a real possibility, 
although no company has admitted to such. Unfortunately, there is 
no way in which this reason for noncompliance with SSAPs can be 
tested. 

Uncertainty Qualifications 

3. Some companies' annual accounts are qualified because the ac- 
counting records and procedures are incomplete in some way (such as 
destruction of accounting records or absence of internal control 
procedures) and the auditors have little or no confidence in them. 
Although such qualifications could happen to any company, they 
might occur more frequently in smaller companies because they have 
smaller resources and are likely to have less sophisticated accounting 
systems and smaller, or perhaps no, internal control procedures. 
Additionally, these types of qualification may well be associated with 
delays in the annual accounts being published (that is, the annual 
accounts being published later than in the previous year). 

4. It is hypothesized that companies who have suffered poor financial 
results are more likely to receive uncertainty qualified audit reports 
because they may rely heavily on banking support (which may result 
in going-concern qualifications), and/or there may be doubts on the 
value of their assets (for example, question as to whether inventories 
can actually be sold). Thus, companies which report losses, or 
reduced earnings-per-share results, may be more likely to receive 
audit qualifications. Likewise, a poor share price performance, which 
could indicate unexpectedly poor earnings results, may be associated 
with an audit qualification. 

5. The presence of extraordinary items in companies' annual ac- 
counts may be associated with audit qualifications. The fact that an 
exceptional and material event has occurred may increase uncer- 
tainties in the financial position of the company (for example, the 
exceptional losses incurred when a factory is closed may lead the 
auditor to think that further costs might still be incurred). 

6. There may be an industry impact associated with uncertainty 
qualified audit reports, that is, a specific industry (for example, 



Cross-Sectional Analysis of Audit Reports 51 



property) may experience a difficult period, with many companies 
reporting losses, and thus audit qualifications may be prevalent. 

The Auditor 

7. The specific firm of accountants involved in an audit may have 
some influence on the occurrence of qualifications. Research from 
elsewhere 6 has shown that individual auditors and firms of auditors 
reach different judgments in materiality decisions, and thus it is quite 
possible that one company could receive a qualified audit report from 
auditor A, while another, but identical, company may receive a clean 
audit report from auditor B. As noted earlier, the auditing profession 
has become concerned about the weight of public criticism and about 
the increased possibility of legal actions being brought, and some 
auditing firms may be taking more stringent views on materiality and 
other judgment matters. 

8. The reasoning in the preceding paragraph may apply only to a 
certain set of companies. For example, auditors may be reluctant to 
qualify the accounts of a large-size company on the grounds that it 
may lose the audit work and the large fees that go with it. Thus, if an 
auditor begins to employ more stringent standards, these may first be 
effected against smaller companies. Other reasons for an association 
with size can be noted: 

(a) Larger companies have more sophisticated accounting pro- 
cedures and therefore the auditors may place more reliance on the 
annual accounts presented to them. Thus, again we would expect to 
find audit qualifications associated with smaller companies. 

(b) A counter reason has been pointed out by Gosman 7 and by 
Warren 8 ; they suggest the possibility that larger companies are more 
in the public light and thus auditors may be especially careful and 
more willing to qualify their audit reports (additionally, legal actions 
in respect to large companies would be more expensive!). 

9. A case can also be made for auditors' tending to qualify the 
accounts of companies which have suffered a poor share-price per- 
formance. If auditors are concerned about possible litigation in 
respect to companies that become bankrupt, they may become more 

6 P. Frishkoff, "An Empirical Investigation of the Concept of Materiality in Account- 
ing," Empirical Research in Accounting: Selected Studies 1970, Journal of Accounting 
Research (Supplement 1970). T. R. Hofstedt and G. D. Hughes, "An Experimental 
Study of the Judgment Element in Disclosure Decisions," Accounting Review (April 
1977); and F. Neumann, "The Auditing Standard of Consistency, " Empirical Research 
in Accounting: Selected Studies 1968, Journal of Accounting Research (Supplement 
1968). 

'Gosman, "Accounting Changes." 
"Warren, "Auditing Standards." 



52 INTERNATIONAL JOURNAL OF ACCOUNTING 



cautious when dealing with companies which have had abnormally 
poor share-price returns. 

RESEARCH DESIGN 

Population 

The sample population consisted of the largest 1500 stock exchange- 
quoted companies in the United Kingdom. The audit reports of these 
companies, released in 1976, were then examined. A total of 185 audit 
qualifications were found, and of these, 116 could be broadly cate- 
gorized as uncertainty qualifications. The remaining 69 qualifica- 
tions generally consisted of firms which had not followed recom- 
mended accounting practices as enunciated in Statements of Standard 
Accounting Practice. 

The separation of audit qualifications into uncertainty andSSAP 
categories was thought necessary as they relate to fundamentally 
different auditor opinions, and the companies involved may have 
significantly different financial characteristics. (Warren's study in the 
United States also differentiated between types of audit qualifica- 
tions. His groupings were uncertainty and consistency qualifica- 
tions, and these had some contrasting cross-sectional characteris- 
tics. 9 ) Previous research into audit qualifications in the United 
Kingdom showed that investors and bankers differentiated between 
uncertainty and SSAP qualifications. 10 Separate statistical analyses 
were therefore run for uncertainty and SSAP qualifications. 

Another twenty-two companies had both uncertainty and SSAP 
qualifications, and this raised the problem of which grouping should 
be used. In the results reported later, such dual qualifications were 
omitted altogether. However, the analyses were also rerun where the 
qualifications were regarded as both an uncertainty and an SSAP 
qualification; however, this made no difference to the results and 
conclusions. 

Research Methodology 

The study used analysis of variance (ANOVA) to examine whether 
there was any relationship between the variables and qualified audit 
reports. ANOVA allows us to analyze direct relationships (for example, 
Coopers Sc Lybrand issues a higher percentage of qualifications than 
does Peat, Marwick, Mitchell) and interactive relationships (Price 
Waterhouse issues a higher percentage of qualifications for small 



9 Ibid. 

10 Firth, "Audit Reports." and "Lending Decisions." 



Cross-Sectional Analysis of Audit Reports 53 



firms which have losses in the current year, than does Touche Ross). 
Measuring interactive relationships is important because although, 
for instance, one auditing firm issues proportionately more qualified 
opinions than another, this may be due to the firm auditing an 
exceptionally high number of companies experiencing losses (making 
the assumption that companies incurring losses are more likely to 
receive qualified audit reports). 

In addition to the ANOVA tests, the Mann-Whitney U test was also 
applied to the size, change in earnings-per-share, and share-price 
variables to determine whether there were any significant differences 
between qualified companies and those receiving clean audit reports. 

Variables 

A total of eight variables was extracted for each company in the 
sample population. These were then examined to see if they had any 
relationship or interactive relationship with qualified audit reports. 
The variables were chosen on the basis of their having some influence 
or association with qualified reports (see Hypothesis section) and so 
as to provide a comparison against similar research in the United 
States. The variables were as follows: 

1. Auditing firm. To ascertain if a specific auditor was strongly 
associated with the occurrence of qualified audit reports, the names of 
the professional auditors were extracted. These were grouped into 
nine categories, eight relating to the eight major accounting firms 
(Arthur Young McClelland Moores; Coopers and Lybrand; Deloitte 
Haskins and Sells; Peat, Marwick, Mitchell; Price Waterhouse; 
Thomson McLintock; Touche Ross; and Whinney Murray) and one 
group relating to other auditors. 

Gosman 11 and Cushing and Deakin 12 reported some differences 
between auditors in the United States when making consistency 
qualifications; in contrast, Warren found no significant relation- 
ships for either consistency qualifications 13 or uncertainty qualifi- 
cations. 14 

2. Size. It has been hypothesized that size may have an association 
with the incidence of audit qualifications (Hypotheses 3, 8). The 
sample population companies were classified as large and small, 
depending on whether they were above or below the population 

"Gosman, "Accounting Changes," and "Reply." 
12 Cushing and Deakin, "Accounting Changes." 
l3 Warren, "Consistency Exceptions." 
14 Warren, "Auditing Standards." 



54 INTERNATIONAL JOURNAL OF ACCOUNTING 



median value for capital employed. An alternative definition of size 
was also analyzed. This related to whether the audit fee was large 
(above the median) or small (below the median). It can be used to 
provide some evidence on whether accounting firms are more reluc- 
tant to qualify the accounts of companies with large audit fees 
(Hypothesis 8). 

Gosman 15 and Warren 16 found that larger-sized companies tended 
to have a statistically significant greater number of consistency' qual- 
ifications than smaller companies 17 and vice versa for uncertain tv 
qualifications. 18 

3. Industry. An analysis of the broad industry grouping of each 
company was made to determine whether audit qualifications had a 
higher relative incidence in some activities than for others (Hypoth- 
eses 1, 6). Thirteen industry groups were selected based on the 
Financial Times industrial subsections. The groupings were bank- 
ing insurance and finance, breweries and entertainment, building 
materials and construction, chemicals and pharmaceuticals, engi- 
neering and electricals, food manufacturing and retailing, mining 
and oil. motors and distributors, newspaper publishing and packag- 
ing, property, stores, textiles, and others. 

Warren found a significant industry impact for both uncertainty 19 
and consistency 20 qualifications in the United States. Gosman, 21 and 
Cushing and Deakin 22 found no industry differences, however, in 
their studies of consistency qualifications. 

4. Extraordinary items. The existence of extraordinary items may be 
associated with qualified audit reports (Hypothesis 5). Previous 
research in the United States has shown that the presence of extra- 
ordinary items tends to be associated with qualified audit reports. 23 

5. Profit or loss. The reporting of a net loss may be associated with a 
qualified audit report (Hypothesis 4). Warren found a significant 
relationship between companies reporting losses and those receiving 
audit qualifications. 24 

6. Increase decrease in earnings per share. For similar reasons as the 
"profit or loss" variable, it may be that firms experiencing decreases 

,5 Gosman, "Accounting Changes," and "Reply." 

'"Warren, "Consistency Exceptions," and "Auditing Standards." 

17 Bremser, "Earnings Characteristics," found no significant relationships. 

"AVarren. "Auditing Standards." 

'"Ibid. 

20 Warren, "Consistency Exceptions." 

21 Gosman, "Accounting Changes," and "Reply." 

22 Cushing and Deakin, "Accounting Changes." 

-' 'Warren, "Auditing Standards." 

24 Ibid. 



Cross-Sectional Analysis of Audit Reports 55 



in earnings per share are associated with audit qualifications 
(Hypothesis 4). An examination of each company was therefore made 
of whether it increased its earnings per share over the previous year by 
more than 2 percent (defined as an increase), decreased its earnings 
per share (EPS) by more than 2 percent (defined as a decrease), or its 
earnings per share changed by up to plus or minus 2 percent (defined 
as no significant change). Another possible variable which could 
have been examined was to have recorded whether the change in EPS 
was above, the same as, or below the average for all companies. 

Warren found a significant relationship between companies expe- 
riencing reduced earnings and those receiving audit qualifications. 25 
Bremser found a similar relationship for consistency qualifications, 26 
although Warren's own study on these types of qualifications did 
not. 27 

7. Increase decrease in share price. A share-price performance var- 
iable was included in the study since it could be hypothesized that 
companies suffering unexpectedly poor stock market returns may 
have greater uncertainty attached to them; thus, audit qualifications 
may be more frequent (Hypotheses 4, 9). The share-price performance 
for each company was ascertained by measuring the percentage 
difference between the actual monthly returns and the expected 
monthly returns over the twelve-month period prior to the release of 
the audit report. 

The expected return E(R„) is derived from the market model 
relationship 

E(Rjt) = 0jM, 

where R\ = the systematic risk coefficient of security j. This coefficient 
was calculated by regressing the monthly returns for security j on the 
monthly returns of the market index for a period of sixty months, 
ending twelve months prior to the audit qualification. 

M t = the return on the market index in month t. 

If a company's risk-adjusted percentage change in share price came to 
over +2 percent, then it was termed an increase; if it was below -2 
percent, it was termed a decrease, and if it was between +2 percent and 
-2 percent, it was termed no significant change. 

"Ibid. 

26 Bremser, "Earnings Characteristics." 

"Warren, "Consistency Exceptions." 



56 INTERNATIONAL JOURNAL OF ACCOUNTING 



8. Increase / decrease in the time taken to publish accounts. The final 
variable related to whether it took a longer, shorter, or similar 
amount of time to publish the accounts after the year end than in the 
previous year. Various hypotheses (1, 3) have been suggested associat- 
ing delays in the time before the annual accounts are published and 
the occurrence of qualified audit reports. Each firm was classified by 
whether it took over 5 percent (in the number of days) longer to 
publish its accounts (an increase), whether it took over 5 percent less 
(a decrease), or whether it took within plus or minus 5 percent (no 
significant change). Warren found a significant relationship between 
overdue accounts (those taking longer to appear) and uncertainty 
qualifications 28 ; he found no such relationship for consistency quali- 
fications, however. 29 

RESULTS 

Two separate ANOVAs were run, one relating to uncertainty qualifi- 
cations and the other to SSAP qualifications. A total of 1,409 com- 
panies (1 16 uncertainty qualifications and 1,293 unqualified reports) 
were included in the uncertainty ANOVA and 1,362 companies (69 
SSAP qualifications and 1,293 unqualified reports) were included in 
the SSAP ANOVA. 

Uncertainty Qualifications 

1. Auditor. None of the main or interactive effects of the auditor 
were statistically significant. Thus, there was no evidence of any one 
firm of auditors or groups of auditors qualifying a significantly 
greater proportion of annual accounts. The breakdown of the 
percentage of audit qualifications by auditing firms is shown in 
column 2 of exhibit 1. 

2. Size. Size was measured in two ways, one based on total capital 
employed, the other based on the audit fee. Neither variable was 
statistically significant, however, either as a main or an interactive 
effect. Thus, none of the "plausible reasons" for size being associated 
with the occurrence of audit qualifications (Hypotheses 3, 8) has 
received support. In particular, there is no evidence that auditors are 
more reluctant to qualify the audit reports of larger firms because of 
their large fees or because they possibly use more sophisticated 
accounting systems. The impact of size was also analyzed by the 
Mann-Whitney U Test. Again, no significant relationship between 



28 Warren. "Auditing Standards." 
29 Warren, "Consistency Exceptions." 



Cross-Sectional Analysis of Audit Reports 57 



Exhibit 1. Percentage of Audit Qualifications by Auditing Firms* 



1 


2 




3 




Uncertain 


ity 


SSAP 




qualifications 


qualifications 


Arthur Young McClelland Moores 


8.7 




5.0 


Coopers and Lybrand 


9.2 




5.5 


Deloitte Haskins and Sells 


7.1 




4.0 


Peat, Marwick, Mitchell 


8.1 




5.6 


Price Waterhouse 


7.4 




6.1 


Thomson McLintock 


8.9 




4.3 


Touche Ross 


8.2 




4.8 


Whinney Murray 


8.0 




5.2 


Other 


8.3 




5.0 


Overall 


8.2 




5.1 



•The number of qualified audit reports given by an auditing firm as a percentage of all reports 
issued bv them in the ANOVA population. 

size and audit qualifications could be found for any of the auditor 
groupings. 

3. Industry. The ANOVA failed to reveal any significant main or 
interactive effects of industry on audit qualifications. In contrast to 
American results, 30 there was no evidence to suggest that the British 
accounting profession applies different auditing standards to differ- 
ent industries or that audit conditions are significantly different 
across industries in the period studied. 

4. Other variables. As hypothesized earlier (Hypotheses 1, 2, 4, 5, 9), 
the remaining variables of extraordinary items (F = 35.62, p < .01), 
profit or loss ( F = 13.62, p<.01), increase/decrease in EPS (F = 9.21, p 
< .01), share-price performance (F = 22.42, p< .01 ), and the time taken 
to publish the annual accounts (F = 6.11, p < .01), were all highly 
significant at the .01 level. Thus companies which report extra- 
ordinary items, net losses, decreases in EPS, and which suffer a poor 
share-price performance, and whose annual accounts are late, are 
much more likely to receive an uncertainty qualified audit report 
than other companies. Apart from the share-price performance anal- 
ysis (which was not examined in the United States), these results are 
similar to those found by Warren. 31 The Mann-Whitney U Test was 
also used to examine the percentage change in earnings per share and 
the percentage change in the risk-adjusted share-price performance of 
the population companies. The results showed that these items were 

50 Warren, "Auditing Standards." 
"Ibid. 



58 INTERNATIONAL JOURNAL OF ACCOUNTING 



significantly associated with audit qualifications at the .01 level, and 
this is consistent with the ANOVA results. 

The ANOVA results showed that there was no interactive relation- 
ship between the above items and the auditor, size, and industry 
variables. Not surprisingly, significant interrelationships were found 
between the reporting of extraordinary items, a decline in earnings 
per share, and a poor share-price performance. These variables all 
tended to be present together in uncertainty qualified audit reports. 

SSAP Qualifications 

The ANOVA results for SSAP qualifications again revealed no 
significant main or interactive effects for auditing firms. Column 3 of 
exhibit 1 reports the percentage breakdown of SSAP qualifications by 
the firm of auditors involved. Similar nonrelationship findings were 
also obtained for size and industry. Thus, although some industries 
supposedly have greater problems in implementing specific SSAPs, 
there was no statistically significant evidence of this in 1976. The 
results for auditors, size, and industry contrasted with some of the 
American research for consistency qualifications referred to earlier. 

The profit or loss, increase decrease in EPS, increase decrease in 
share price, and the increase/decrease in time taken to publish annual 
accounts variables were all nonsignificant, contrasting sharply with 
the uncertainty qualifications where these factors were highly sig- 
nificant. Thus, the financial state of the company and the relative . 
share-price performance of the company have no relationship with 
the incidence of SSAP qualifications. The Mann-Whitney U Test 
also verified these findings. 

The only variable which was significant was that of extraordinary 
items. Here there was a significant relationship between companies 
reporting extraordinary items and the incidence of qualified reports 
(F= 12.1 1, p<.01). Some of the qualifications were related to SSAP 6 32 
which defined what should be included in extraordinary items. Many 
companies have not complied with the SSAP because they have 
included items as extraordinary items which were outside the defini- 
tion of the standard — hence the qualified audit report. Warren found 
a significant relationship in the United States between the reporting 
of extraordinary items and the receipt of a consistency qualification. 33 

"Institute of Chartered Accountants in England and Wales, "Extraordinary Items and 
Prior Year Adjustments." Statement of Standard Accounting Practice 6 (London: 
ICAEW, 1974). 
"Warren, "Consistency Exceptions." 






Cross-Sectional Analysis of Audit Reports 59 



CONCLUSIONS 

This study has used ANOVA techniques to examine whether there 
were any common, differentiating characteristics of firms receiving 
uncertainty audit qualifications and SSAP audit qualifications. In 
contrast to American research, the specific auditing firm, the size of 
the company, and the industry within which it operates were all 
found to be independent of receiving any type of audit qualification. 
However, uncertainty qualifications were found to be related to firms 
suffering poor financial performance; explanations for this have been 
discussed earlier. SSAP qualifications were not related to poor finan- 
cial performance. The fact that there is some difference between 
uncertainty and SSAP qualifications is consistent with earlier re- 
search concerning audit qualifications in the United Kingdom, 
which showed that investors viewed uncertainty qualifications with 
far more concern than they did SSAP qualifications. 34 Both uncer- 
tainty and SSAP qualifications were found to be associated with 
companies reporting extraordinary items in their annual accounts. 
The results of the research were consistent with uniform auditing 
standards. Specifically, none of the nine auditor groupings were 
significantly associated with either uncertainty or SSAP qualifica- 
tions (earlier research by Firth showed that the extent of share-price 
adjustments resultant on the release of qualified audit reports was 
independent of the auditing firm 35 ; this is also consistent with 
uniform auditing standards). Further research into the cross-sectional 
characteristics of qualified audit reports could take the form of 
examining qualifications in other time periods, incorporating other 
variables for interactive analysis, and making a closer study of the 
uniformity of auditing standards, including further studies of the 
judgment processes of auditors. 



34 Firth, "Audit Reports," and "Lending Decisions.' 
35 Firth, "Audit Reports." 



Information Content of Accounting Numbers: 
Evidence on Tokyo Stock Exchange Firms 

KEIICHI KUBOTA* 

INTRODUCTION 

While ample evidence is available of the association between account- 
ing numbers and stock market returns of American firms, little is 
known of this topic for Japanese firms. 1 This paper hypothesizes that 
accounting numbers published in Japan convey information on 
security returns. Empirical tests are conducted to determine the 
accuracy of this assertion. To formulate testable hypotheses in in- 
vestigating the information content of accounting numbers, the 
Japanese capital market is assumed to be efficient in a semi-strong 
form and the publicly available information is presumed to be 
impounded into stock prices instantaneously after it is published. 
Accounting numbers are said to have information content if these 



* Keiichi Kubota is assistant professor of finance and accounting, Department of 
Economics, Musaski University, Japan. The author expresses his appreciation to 
Professor Rinya Shibakawa for helpfully providing his data, and to Dean Robert S. 
Kaplan and Professors Katherine Schipper and Rex Thompson for several helpful 
comments. 

'Taya investigated the price movement of the eight most actively traded firms on the 
Tokyo Stock Exchange. In his study, the independence of price changes was statis- 
tically rejected, but the process was consistent with martingale models. SeeT. Taya, "A 
Study on the Movement of Stock Prices in the Tokyo Stock Exchange" (Ph.D. disserta- 
tion, University of California at Los Angeles. 1977). Kobayashi investigated thirty-one 
firms and found that the speed of adjustment to the new information was not as fast as 
with New York Stock Exchange firms. See S. Kobayashi, "Kabushiki-shijo no Koiti- 
susei no Hyoka (1)," Zaikai Kansoku (February 1975): 22-29. Deakin, Norwood, and 
Smith also found a slight inefficiency of price changes around the announcement 
weeks of financial reports. E. B. Deakin, G. R. Norwood, andC. H. Smith, "The Effect 
of Published Earnings Information on Tokyo Stock Exchange Trading," Interna- 
tional Journal of Accounting (Fall 1974): 123-36. 



62 INTERNATIONAL JOURNAL OF ACCOUNTING 



numbers convey information pertaining to firms' production- 
investment and financing decisions and their outcome, and accord- 
ingly can revise agents' beliefs on realized returns on securities. Ball 
and Brown found that accounting numbers tested have information 
content and that the publicly available information is instanta- 
neously impounded into stock prices. 2 Specifically, they found that 
earnings-per-share numbers and net income numbers acquired a year 
in advance can help investors incur abnormal security returns based 
on this information. Furthermore, they note that cash-flow numbers, 
as approximated by operating income and net income numbers 
before nonrecurring items, do not outperform those two series in 
predicting security returns. 

Gonedes tested whether a joint set of accounting numbers has 
information content significantly different from that contained in the 
net income. That is, "one can and may argue that information re- 
flected in contemporary accounting reports is jointly determined by 
several or all of the accounting numbers presented in those reports." 3 
To test this assertion, he chose a linear combination of financial 
ratios estimated with discriminant analysis and compared the per- 
formance of this set with other single financial ratios. The evidence 
he found is that the expected effect of the information reflected in each 
financial ratio and the linear model is no greater than the expected 
effect of the information reflected in earnings-per-share numbers. In a 
similar test by Kubota, a bankruptcy-prediction model estimated by 
the author was used as a surrogate for the linear combination of 
financial ratios, and he found that the linear model or other ratios did 
not significantly outperform earnings-per-share numbers, although 
the point estimate of the net income/total sales ratio was a better 
predictor than the earnings per share. 4 

Note that in these studies, only pair-wise comparisons of security 
returns earned on the information from different accounting num- 
bers were conducted, and among them, the most informative account- 
ing numbers were selected with predictive ability criterion. However, 
Gonedes investigated the information content jointly reflected in 
accounting numbers with a more sophisticated methodology using 



2 R. Ball and P. Brown, "An Empirical Evaluation of Accounting Income Numbers," 
Journal of Accounting Research (Autumn 1968): 159-78. 

3 N. Gonedes, "Capital Market Equilibrium and Annual Accounting Numbers: Empir- 
ical Evidence." Journal of Accounting Research (Spring 1974): 26-62. 
4 K. Kubota, "Information Content of Joint Accounting Numbers" (Carnegie-Mellon 
University, November 1977). 



Information Content of Accounting Numbers 63 



Exhibit 1. Classification Table for Two Accounting Signals 





0^0 


0>O 


0sSO 


Ji.i 


J.,2 


0>O 


J2,> 


Jv 



dud) = forecast error of accounting signals (first 

difference of Martingale process) 

Jk i = number of observations which fall into the 

category (k,l). 

three numbers series: net income, extraordinary items, and dividends. 5 
He found that extraordinary items and dividends numbers do not 
contain information more than that reflected in net income numbers. 
Similar tests were also conducted by Beaver and Dukes 6 and Patell and 
Kaplan. 7 Both studies found that cash-flow numbers do not add 
information content more than that reflected in net income numbers. 
The current study investigates the information content jointly 
reflected in accounting numbers and dividend payment of Tokyo 
Stock Exchange firms of which numbers are publicly disclosed in 
accordance with Japanese accounting standards. Although the Tokyo 
Stock Exchange is the second largest in the world next to the New 
York Stock Exchange (NYSE), its disclosure level is far from complete 
compared to the American one. Hence, it seems interesting to detect 
the magnitude of the association between security returns and ac- 
counting numbers and get the insight into the usefulness of financial 
reports. 

DATA AND DISCUSSION 

The collection of the data is based on the tape initially produced by 
the Nomura Research Institute and expanded by Aoyama Gakuin 
University. The following criteria were used to select the data, and 
298 firms satisfied the requirement. 

1 . The securities are listed on the Tokyo Stock Exchange for the fiscal 
years between 1961 to 74. 

5 N. Gonedes, "Corporate Signaling, External Accounting and Capital Market Equil- 
ibrium: Evidence on Dividends, Income and Extraordinary Items," Journal of Ac- 
counting Research (Spring 1978): 26-79. 

6 W. H. Beaver and R. E. Dukes, "Interperiod Tax Allocation, Earnings Expectations, 
and the Behavior of Security Prices," Accounting Reinew (April 1972): 320-32. 
7 J. M. Patell and R. S. Kaplan, "The Information Content of Cash Flow Data Relative 
to Annual Earnings: Preliminary Test" (Paper presented at the Stanford Accounting 
Seminar, August 1976). 



64 INTERNATIONAL JOURNAL OF ACCOUNTING 



2. Fiscal year ends on March 31 and September 31 semi-annually. 

3. Monthly rates of return adjusted for dividends between the time 
period of January 1961 and December 1974 were available. 

4. Accounting data were available between the time period of Jan- 
uary 1965 and November 1974. 

The list of accounting numbers used for the information content 
test is found in exhibit 2. 8 In the exhibit, note that the after-tax net 
income figures are reported as numbers before bonuses and dividend 
payments. These payments must be voted by a shareholders' meeting 
which is normally held two months after the end of the fiscal year. 
However, as far as the public disclosure is concerned, those numbers 
are reported at the same time as net income after taxes; the net income 
after taxes, bonus, and dividends is considered more useful in setting 
security prices at the time of disclosure. 

Similarly, recompute cash-flow numbers, as approximated by the 
income number to which depreciation and other noncash expense 
items are added back. Along with this number, the net operating 
income, which is the number before interest expense, taxes, and extra- 
ordinary items, will also be included in the comparison of the 
information content. Exhibit 3 indicates the time series trend of 
income numbers and income ratios, and the net income shows some 
upward trend while other ratios are more stationary. 

Secondly, with respect to the information content of dividend 
payments, unlike Gonedes' study 9 where Lintner's model 10 is used as 
a market expectation model, different market expectations models are 
suggested for Japanese firms. The "dividends-payout ratio" which is 
widely used in Japan is defined as the ratio of dividends per share to 
the par value of common stock per share. It is not equivalent to the 
dividends-per-share number in the sense that each share may have a 
different par value. However, since we are interested only in the 
change of accounting variables around their previous period's market 
expectations, under the assumption of the martingale process, the 
information content contained in those two variables is equivalent. 
Japanese firms tend to keep their dividend payout ratios and change 



8 It should be noted thai the information on dividends is the economic variable rather 
than the accounting signal in the sense that it is free of the particular accounting 
technique choice. Hence, we are testing the information content included in account- 
ing reports versus economic variables when comparing the performance of accounting 
variables and dividend information information in predicting security returns. 
9 Gonedes. "Corporate Signaling," pp. 26-79. 

10 J. Lintner. "Distribution of Incomes of Corporations among Dividends. Regained 
Earnings, and Taxes." American Economic Rei'iew (May 1956): 55-61. 



Information Content of Accounting Numbers 65 



Exhibit 2. Accounting Variables Used for Information Content Test 

A. Income number series 
I. Net income numbers 



Net income after taxes 

Net income after taxes /Sales 

Net income after taxes Total assets 



II. Net income adjusted* 



Net income adjusted 

Net income adjusted Sales 

Net income adjusted Total assets 



III. Cash-flow series** 



Cash flow/Sales 

Cash flow /Total assets 



IV. Net operating income*** 



Net operating income 

Net operating income/Sales 

Net operating income/Total assets 



B. Dividends 



Total dividend payment 
Dividend payout ratio 



C. Leverage ratios and other ratios 



Current assets/Current liabilities 
Total loans**** Total assets 
Retained earnings/Total assets 
Inventorv Sales 



•Net income adjusted = net income after tax-bonus-dividends. 

"Cash flow = Net income adjusted + Depreciation + Noncash expenses. 

***Net operating income = Income before tax. interests, and extraordinary items. 

••••Total loans = Short-term bank loans + long-term bank loans. 



those numbers rather infrequently (see exhibit 7). Hence, the expec- 
tation model we use for this variable will be the historic payout ratio, 
and any deviation from this historic trend will be hypothesized to 
have signalling implications. Note also that the average level of 
dividend payout ratios is slightly higher than 10 percent, as is seen in 
exhibit 4, which was a conventional payout ratio among Japanese 
firms. Then, this market expectations model will be compared with 
the estimated time-series model of total dividend payment with the 
predictive ability criterion. 

Finally, it is well known that Japanese firms have higher debt- 
equity ratios than U.S. firms as demonstrated in exhibit 3 with the 
level of approximately 70 percent in book values with the increasing 



66 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 3. Summary Statistics of the Average Series (n = 163) 

Net income Net income Net income/ Total debt 
Year* (million yen) Total assets (%) Sales (%) Total assets (%) 

1955 
1956 
1957 
1958 
1959 
1960 
1961 
1962 
1963 
1964 
1965 
1966 
1967 
1968 
1969 
1970 
1971 
1972 
1973 
1974 



•Fiscal vear ends on March 31 and September 31 semi-annually. 



140 


1.45 


2.12 


57.07 


175 


1.85 


3.38 


57.08 


198 


1.81 


3.05 


57.74 


250 


2.20 


3.70 


58.57 


310 


2.38 


4.10 


59.79 


314 


2.11 


3.77 


62.24 


277 


1.74 


3.37 


61.15 


250 


1.55 


3.04 


60.76 


289 


1.66 


3.29 


61.20 


343 


1.77 


3.32 


62.73 


413 


1.83 


3.48 


64.04 


493 


1.91 


3.63 


64.73 


551 


1.88 


3.70 


66.28 


611 


1.81 


3.63 


66.62 


679 


1.76 


3.72 


66.20 


628 


1.50 


3.16 


66.69 


620 


1.44 


3.29 


67.03 


712 


1.46 


3.30 


67.91 


703 


1.29 


2.68 


68.92 


761 


1.14 


2.32 


69.89 


742 


1.10 


2.49 


70.06 


565 


.707 


1.35 


70.55 


570 


.732 


1.27 


70.58 


750 


.918 


1.83 


70.65 


883 


1.08 


2.34 


70.85 


1,027 


1.33 


2.70 


70.90 


1,141 


1.45 


2.89 


71.70 


1,257 


1.53 


3.02 


72.02 


1,392 


1.58 


3.05 


72.26 


1,548 


1.57 


3.09 


72.36 


1,771 


1.61 


3.23 


72.84 


1,837 


1.50 


2.95 


73.18 


1,673 


1.33 


2.69 


73.55 


1,310 


.814 


1.78 


74.11 


1,246 


.768 


1.56 


74.13 


1,443 


.730 


1.52 


74.09 


1,856 


.987 


2.04 


74.65 


2,448 


1.12 


2.26 


75.62 


2,288 


1.08 


2.09 


76.93 


1,909 


.909 


1.67 


76.67 



Information Content of Accounting Numbers 67 



Exhibit 4. Distribution of Dividend Payout Ratio (n = 301). 



End of fiscal year 


Lower than 10% 


10% 


Higher than 10% 


65 March 


88 


70 


143 


65 September 


100 


72 


129 


66 March 


102 


75 


122 


66 September 


102 


75 


124 


67 March 


93 


83 


125 


67 September 


82 


91 


128 


68 March 


77 


90 


134 


68 September 


69 


92 


140 


69 March 


62 


93 


146 


69 September 


50 


96 


155 


70 March 


44 


84 


173 


70 September 


50 


77 


174 


71 March 


56 


78 


167 


71 September 


77 


78 


146 


72 March 


95 


73 


133 


72 September 


95 


71 


135 


73 March 


73 


83 


145 


73 September 


55 


81 


165 


74 March 


56 


83 


162 


74 September 


55 


85 


161 



trend. The test of information content on this variable reveals any 
association between the abnormal return and the change in leverage 
ratios, although its implication is not clear-cut since there is no 
formal theory that connects the abnormal return and the financial 
structure. 

TESTING METHODOLOGY 

Under market efficiency, all publicly available information is in- 
stantaneously impounded into the equilibrium price of securities. 
Hence, the effect of any new inside or hypothetical information upon 
security returns is an unexpected one which had not been fully 
incorporated into the equilibrium price before this information 
arrived into the market. This association between the new informa- 
tion and the unexpected change in security returns is what we call 
information content, and the following methodology is used to detect 
this information content. 
Let 

Vi,t = the accounting number of firm i that becomes publicly 
available at the end of period t; 



68 INTERNATIONAL JOURNAL OF ACCOUNTING 



0, fI = unanticipated change in the accounting number y,,, in 

period t; 
Ri, t = the return of the security i in period t; 
e,, t = unanticipated change in the return of the security i in 
period t; and 
</> m ,t = a set of publicly available information at the beginning of 
period t. 

Define 

M = yi, t -E(y if t|0m,t) (!) 

and 

e,, t = Ri,t-E(Ri,t|4>m,t). (2) 

Then, the study attempts to determine whether the unanticipated 
change in accounting signals, that is, the realization of 0, )t , is posi- 
tively correlated with the realization of the unanticipated change in 
security return ei, t . To test this assertion, the foreknowledge of the 
realization of accounting numbers by capital market agents is 
assumed as a hypothetical experiment, and it is inferred that this 
foreknowledge can be utilized by agents to earn excess returns over the 
equilibrium rate of return. 

Let the market model be of the form (3), 

R,, t = a, + /3,R m ,i + ei,t (3) 

E(ei,t) = O 
V(€i,.) = a 

where 

R m ,t = the monthly return of the value weighted portfolio. 

Then, the estimated excess returns can be defined as follows. 

e,, t = Ri,t-(oi + £iIU f t). (4) 

Under capital market efficiency, this excess return is a "fair-game" 
random variable, and its expected value is zero. 

Since little evidence is available on the time-series properties of 
accounting numbers published in Japan, it seems necessary to inves- 
tigate and identify the stochastic processes generating these series. 
However, to get the first approximation of the appropriate stochastic 



Information Content of Accounting Numbers 69 



process for each financial ratio listed in exhibit 2, we assume the 
process is the martingale of the following form: 

yt = y t -i + 77, (5) 

E(T7 t )= O. 

Then, 

Et-i (y t ) = yt-i. 

The difference between the realized accounting number and its ex 
ante market expectations derived from these models is called "forecast 
error" and denotes the unexpected change of the accounting numbers 
relative to prior periods' market expectations. When agents can gain 
access returns on the foreknowledge of this forecast error, accounting 
numbers are said to have information content. In other words, the 
new information n ,t is said to have information content if capital 
market agents revise their expectations after they receive a signal n ,t 
in addition to the already publicly available information set m , t . 

Definition 1 

n ,t is said to have information content, if 

E(|e,||(9 n , t , 4> m ,,)^E(|e,||0 m , t ) 

where |e,| is the absolute value of e,. When agents receive distinct 
signals from two information sets n> , and k , t , we define the informa- 
tion content of the information system as follows. 

Definition 2 

n ,t is said to be more informative than 0k )t , if 

E(|e,||0 n ,t, 4> m ,,)^E(|e,|J0 k) ., </>m,«). 

For example, one may wish to test whether net income numbers 
before extraordinary items are more informative than net income 
numbers after extraordinary items and may find either of those to be 
more informative than another. 

Definition 3 

n ,t is said to have marginal information content relative to 0k, t , if 



70 INTERNATIONAL JOURNAL OF ACCOUNTING 



E(ki||©n,t n0 k ,,, 4> m>t ) ^ E(|e,||0 k ,„ m ,,). 

In this context, we use information on the net income and dividends 
as one information set and compare the performance of this informa- 
tion set with one of either information sets above. The use of 
intersection implies that this information set is defined only if two 
signals indicate the same signalling implications, for example, the 
positive change in the net income and dividend payment. 

As introduced earlier, we assume capital market agents acquire sure 
and advance knowledge of accounting numbers to be released at a 
later date. If this information is acquired t months before the actual 
announcement of accounting data, agents will either buy or short sell 
securities according to the signalling implication of this information 
and will keep this portfolio position unchanged up to the an- 
nouncement date when the information becomes publicly available. 
To measure the effect of this information, the following statistics are 
defined. Suppose B(S) is the set of securities purchased (sold short) 
and N is the total number of securities. Then, let 

m 1 
API= n -(1 + X e,, t - 1 e,, t ). (6) 

t=-T N ieB ieS 

Since new information is impounded into stock prices as soon as it is 
publicly released under market efficiency. API is cumulated from six 
months before to two months after the announcement month allow- 
ing for a drift after the announcement month. As these residuals are 
cumulated from six months before the announcement date, the 
market model (3) is estimated using the preceding fifty-three monthly- 
returns. 11 The null hypothesis that the accounting signal does not 
have information content is tested by comparing the APIs of these 
purchased and sold-short groups against the overall sample. To find 
which information system is most informative, we compare only the 
APIs based on different accounting signals. Furthermore, to derive 
the marginal information content, we partition the securities into 
four groups as in exhibit 1. That is, the securities are purchased only 
if two signals show the positive forecast errors and short sold with 
negative forecast errors. Then, the APIs of these portfolios are com- 
pared with the portfolio based on only one signal among these two 
different information sets. 

"Any possible seasonality caused by using semi-annual reports is ignored in this study. 
However, the review of autocorrelated functions of original accounting number series 
not reported here shows the seasonality is small enough to be neglected in our test. 



Information Content of Accounting Numbers 71 



As for the significance test, Jaffe provides a relatively powerful test 
of the information content. 12 However, Marshall showed that APIs 
cannot test informativeness. 13 Although Patell proposed an alterna- 
tive test 14 which is similar in essence to that of Beaver and Dukes, 15 it is 
unfortunately not a powerful test. In view of these observations, this 
paper will provide only the point estimates of APIs without statistical 
signifance tests. However, along with the discussion in the following 
section, it will become clear that this is not a drawback, given the 
empirical results of this study. 

EMPIRICAL RESULTS 

Exhibit 5 lists the estimated autocorrelated functions for four income 
number series where first differences were taken for all series. The 
autocorrelated functions and Box-Pierce Q statistics were estimated 
for all 163 firms using thirty-nine observations, and then the average 
values of each were computed and are reported in the exhibit. These 
estimated autocorrelation functions fall within two standard errors 
for all twelve differences, and the independence of disturbance terms 
can be thus inferred (see Nelson). 16 Also, Box-Pierce Q statistics show 
that one cannot reject the hypothesis that the residuals are white noise 
for all four series. This evidence indicates that, as a first approxima- 
tion, we can use martingale process models for accounting income 
series to generate market expectations models. Market models were 
estimated to generate the expected returns of securities, and the result 
is shown in exhibit 6. 

In the information content test, the securities are classified into the 
purchased group and the sold-short group based on the sign of the 
first differences of accounting numbers. Because a smaller number of 
firms changed either the total dividend payment of the dividend- 
payout ratio during the testing period, the numbers of observations 
for the case of dividend signals are very small as seen in columns 3 and 
4 of exhibit 7. The results reported in exhibit 7 indicate that there is no 
substantial difference of information content contained among al- 
ternative income series, that is, the first twelve variables in columns 1 



12 J. F. Joffe, "Special Information and Insider Trading," Journal of Business (July 

1974): 410-28. 

13 R. M. Marshall, "Interpreting API," Accounting Rei'iew (January 1975): 99-1 1 1. 

I4 J. M. Patell, "The API and Model Comparison: Earnings Forecast vs. Naive Earnings 

Expectation Models" (Paper presented at the Stanford Accounting Workshop, August 

1976). 

15 Beaver and Dukes, "Security Prices," pp. 320-32. 

I6 C. R. Nelson, Applied Time Series Analysis: For Managerial Forecasting (San 

Francisco: Holden-Day, Inc., 1973). 



72 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 5. Average of Estimated Autocorrelated Functions of All Firms 

Net income Net income Cash flow Net operating 
adjusted income 



T\ 


.02375* 


-.05004 


-.001105 


.000200 


T2 


-.03311 


-.04526 


.01941 


-.005111 


I"} 


-.1255 


-.1225 


-.05995 


-.1521 


r 4 


-.08411 


-.08276 


-.02045 


-.06071 


Ts 


-.06501 


-.05803 


-.02526 


-.08113 


r& 


.005178 


.007717 


.02558 


.01913 


T7 


-.01232 


-.001096 


-.001298 


.001531 


n 


-.01513 


.000537 


-.01877 


.005327 


r 9 


-.04374 


-.03322 


-.04559 


-.05207 


rio 


-.01207 


-.01613 


-.03921 


-.02224 


rn 


-.01229 


-.01750 


-.02410 


-.01785 


ri2 


.02423 


.03210 


.02739 


.03777 


Box-Pierre Q 


13.33** 


12.388 


13.374 


15.226 



Sample size = 163, T = 39 (20 vears) and first difference. 

•Two standard error = 2 \/T = 0.320. 

••Distributed with x 2 (12). x : = 18.55 at 10% significance level. 



Exhibit 6. Market Model Estimation Result-.Cross-sectional Average 



Jan. 62-May 66* 
July 62-Nov. 66 
Jan. 63-May 67 
July 63-Nov. 67 
Jan. 64-May 
July 64-Nov 
Jan. 65-May 
July 65-Nov 
Jan. 66-May 
July 66-Nov 
Jan. 67-May 
July 67-Nov. 71 
Jan. 68-May 72 
July 68-Nov. 72 
Jan. 69-May 73 
July 69-Nov. 73 



68 

68 
69 

69 
70 

70 
71 



-0.001265 

-0.001254 

-0.001868 

-0.000853 

-0.000524 

0.008436 

0.002429 

0.003291 

0.004928 

0.004268 

0.003824 

0.002201 

0.003840 

0.005010 

0.004897 

0.006694 



1.1487 
1.1430 
1.1209 
1.1803 
1.1947 
1.1442 
1.0719 
1.0054 
1.0253 
1.0090 
0.9706 
0.9601 
0.9592 
0.9186 
0.9120 
0.9307 



T = months. N = 298 firms 
•R, = a, + 0, R m + e, 

•• 

-=- 1 N - 
$ = - .2 & 
N i=l 

- 1 ?- 

a = — Z a, 

N i=] 



Information Content of Accounting Numbers 73 



Exhibit 7. Abnormal Performance Index for Nineteen Signals 
(As of Announcement Month) 





1 


2 


3 


4 




Purchased 


Short-sold 


Positive 
class n\ 


Negative 
class ni 


Net income 


1.0433* 


.93223 


3.543 


1,225 


NI /Sales 


1.0716 


.96654 


2,229 


2,539 


NI/Total assets 


1.0806 


.95920 


2.232 


2,536 


Net income adjusted 


1.0478 


.949383 


3,285 


1.483 


NIA/Sales 


1.0646 


.95672 


2.606 


2,162 


NIA/Total assets 


1.0707 


.95277 


2,555 


2,213 


Cash flow 


1.0395 


.95582 


3,377 


1,391 


CF/Sales 


1.0471 


.98884 


2,131 


2,637 


CF Total assets 


1.0607 


.97642 


2,196 


2,572 


Net operating income 


1.0496 


.94264 


3,250 


1,518 


NOI Sales 


1.0737 


.95723 


2,400 


2,368 


NOI Total assets 


1.0747 


.95482 


2,430 


2,338 


Total dividend payment 


1.0140 


.88437 


1,416 


326 


Dividend payout ratio 


1.0991 


.88731 


567 


369 


Current assets/Total assets 


1.0332 


.99004 


2,727 


2,041 


Total loans/Total assets 


0.9900 


1.0369 


2,255 


2,513 


Total debt/Total assets 


1.0139 


1.0155 


2,929 


1,839 


Retained earnings/ 










Total assets 


1.0276 


.99975 


2,540 


2,228 


Inventory /Sales 


1.0047 


1.0253 


2,496 


2,272 



Sample si?e = 4768 
•All securities : API 



and 2 of exhibit 7. However, the dividend signals seem to be more 
informative than any of the income signals. For example, as of the 
announcement month, the purchased group (the sold-short group) of 
dividend-payout ratio signal earned 5.6 percent more (4.5 percent 
less) than the net income signal group. Exhibit 8 plots the monthly 
behavior of abnormal performance indices for both the purchased 
and sold-short groups based on dividend signal and income signal. 
The plotted line in the middle denotes the API for the total sample, 
and some upward drifts of the residuals are observed for the total 
sample. In every month, the abnormal performance index of dividend 
signal is superior to that of income signal as indicated by a compari- 
son of exhibits 9 and 10. Also, note that most of the information 
contained in financial reports is reflected in security prices two to 
three months before the disclosure date, and, therefore, the evidence is 
consistent with a "semi-strong form" market efficiency. 

Finally, we are interested in whether one can gain additional infor- 



74 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 8. Abnormal Performance Index: Month Relatives 




Exhibit 9. Abnormal Performance Index by Month Relatives: Net Income 

(n - 4,768) 



Month 


Purchased 


Short-sold 


Total sample 


-5 


1.0131 


.99655 


1.0089 


-4 


1.0367 


1.0025 


1.0279 


-3 


1.0469 


.98401 


1.0305 


-2 


1.0492 


.96059 


1.0259 


-1 


1.0472 


.95158 


1.0129 





1.0443 


.93223 


1.0145 


1 


1.0532 


.93897 


1.0228 


2 


1.0758 


.95976 


1.0449 




(n = 3543) 


(n = 1225) 


(n =14768) 



Information Content of Accounting Numbers 75 



Exhibit 10. Abnormal Performance Index by Month Relatives: 
Dividend Payout Ratio 



Month 


Purchased 


Short-sold 


Total sample 


-5 


1.0126 


.99177 


1.0089 


-4 


1.0740 


.98080 


1.0279 


-3 


1.0926 


.94559 


1.0305 


-2 


1.0967 


.91724 


1.0259 


-1 


1.0196 


.90538 


1.0219 





1.0991 


.88731 


1.0145 


1 


1.1107 


.90675 


1.0228 


2 


1.1291 


.92511 


1.0449 




(n = 567) 


(n = 369) 


(n = 4768) 



mation by using the income signal and the dividend signal jointly; 
exhibit 1 1 shows this result. In this case, the securities are purchased 
(sold short) only if two signals show positive (negative) changes. 
Comparison of this exhibit with exhibit 9 indicates that the addi- 
tional gain is 0.7 percent for the purchased group and 4 percent for the 
sold-short group, relative to the case when only the dividend-payout 
ratio signal is used. Although for every month the abnormal per- 
formance index of "two signal case" is superior to that of the dividend 
signal, note that the additional gain is not very large. From this result, 
one may infer that the dividend signal contains information content 
more than that reflected in the accounting numbers. However, as the 
number of observations of the dividend change group is small relative 
to the income group, it may be the case that the dividend signal 
further partitions the income group and thus brings in the magnitude 
effect of the income group by serving as a proxy variable for the 



Exhibit 1 1 . Abnormal Performance Index by Month Relatives: Net Income and 
Dividend Payout Ratio Used Jointly 



Month 


Purchased 


Sold-short 


Total sample 


-5 


1.0136 


.98780 


1.0089 


-4 


1.0767 


.97603 


1.0279 


-3 


1.0953 


.92428 


1.0301 


-2 


1.0983 


.88265 


1.0259 


-1 


1.0934 


.86722 


1.0219 





1.1017 


.84761 


1.0145 


1 


1.1143 


.86884 


1.0228 


2 


1.1324 


.89049 


1.0449 




(n =539) 


(n = 258) 


(n = 4768) 



76 INTERNATIONAL JOIRNAL OF ACCOUNTING 



income signal. This point will not be elaborated upon in this paper, 
but the reader should be cautious in interpreting this result. 

CONCLUSION 

The author found that the accounting numbers and dividend infor- 
mation have information content in predicting security returns with 
respect to Japanese firms. Moreover, it is inferred that the dividend 
signal contains information content more than that reflected in the 
accounting numbers. However, the choice of the particular signal 
among different versions of income numbers and ratios does not seem 
to matter in predicting security returns. Finally, most of the informa- 
tion contained in financial reports is reflected in security prices two to 
three months before the disclosure date and, therefore, the evidence is 
consistent with a "semi-strong form" market efficiency. 



Interim Reports and Their Qualitative Evaluation 



A. J. ROBB* 



Only in recent years have interim financial reports received attention 
from academic and financial accountants. Much has been written of 
the principles underlying interim reporting, 1 the problems of report- 
ing for a seasonal business, 2 and the effect of alternative measurement 
techniques. 3 Little consideration appears to have been given to 
methods of evaluating the quality of reports currently being issued. 
In the course of recent research, the author has developed a technique 
which deals with this problem. 4 

Two factors determine the quality of information in a report: (1) 
the timeliness of the report, and (2) the financial data disclosed. It is 
basic to any definition of information that a report should be timely. 
In fact, the object of presenting interim reports is to overcome the lack 
of timeliness of annual reporting. The less time taken between the 
end of the financial period and the issuing of the report, the more 
useful the report is likely to be. The research conducted in New 



*A. J. Robb is lecturer in accountancy at the University of Canterbury, Christchurch, 

New Zealand. 

'See, for example, J. W. Edwards et al.. Interim Financial Reporting (New York: 

National Association of Accountants, 1972); D. Green, "Towards a Theory of Interim 

Reports," Journal of Accounting; Research (Spring 1964): 35-49; A. Rappaport. 

"Towards a Theory of Interim Reports — A Modification and an Extension," Journal 

of Accounting Research (Spring 1966): 121-26. 

2 W. J. Bollom and J. J. Weygandt, "An Examination of Some Interim Reporting 

Theories for a Seasonal Business," Accounting Rexnew (January 1972): 75-84. 

3 G. Fogelberg, "Interim Income Determination: An Examination of the Effects of 

Alternative Measurement Techniques," Journal of Accounting Research (Autumn 

1971): 215-35. 

4 A. J. Robb, interim Reporting in New Zealand" (M.Com. Thesis, University of 

Canterbury, 1976). 



78 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 1. Timeliness of Interim Reports 

Days from End of Half Year 
Up to Over 

30 31-40 41-50 51-60 61-70 71-80 81-90 91-100 100 Total 

Number of 

companies 1 7489450 2 40 

Percentage 2.5 17.5 10.0 20.0 22.5 10.0 12.5 — 5.0 100.00 

Cumulative 2.5 20.0 30.0 50.0 72.5 82.5 95.0 95.0 100.0 



Zealand analyzed forty interim reports 5 for timeliness. Exhibit 1 
reports the results. However, it is not merely the speed with which a 
report is presented which makes it valuable to shareholders. Clearly 
the content is also important. 

CONTENT 

When annual reports are evaluated for award purposes, it is not 
uncommon to find as many as twenty-five items taken into considera- 
tion 6 in the evaluation. This does not mean that such items must 
always be reported or that their omission necessarily reduces the value 
of a report. In fact, one would intuitively expect interim reports to be 
briefer than annual reports. In any group of items, there are normally 
some which, although few in number, are proportionately more 
important than the remainder. It therefore seemed acceptable when 
examining the content of interim reports to use a smaller set of factors 
than for evaluating annual reports. Five or six factors were considered 
probably sufficient to report accurately the interim results. The 
factors selected were sales, costs, profits, certain balance-sheet in- 
formation, and directors' comments. The reasons for this selection are 
discussed in the following sections. 

Profit 

Profit (or loss) for the period seems to be the most fundamental item 
to be disclosed. Profit is the raison d'etre of virtually all businesses, 
and, despite the acknowledged difficulties of profit measurement in 



5 Of 272 companies listed on the New Zealand Stock Exchange, 67 (24.6 percent) 
voluntarily issued interim reports. The sample of forty reports thus represents 59.6 
percent of the population. Half yearly reporting has since been made obligatory by the 
Stock Exchange Association. 

6 Refer to R. C. Olsson, "The Development of Criteria for Evaluating Annual Reports 
(with Particular Reference to the A. I. M. Annual Report Awards)"; and to D.J. Fraser, 
Awards for Excellence in Company Reporting in Australia and Other Countries" 
(Both papers presented at the 1973 Convention of the Accounting Association of 
Australia and New Zealand. Reprinted as Papers A and B. I 



Qualitative Evaluation of Interim Reports 79 



some enterprises, profit earned in the interim period is as important 
to the investor as profit earned in the annual period. 7 For this reason, 
reference to the interim profit or loss was ranked of first importance 
and given a maximum of nine points. (Refer to the section "Weight- 
ing of Disclosure Methods" for further details of the weightings used 
for each factor.) 

Sales and Costs 

Because profits are determined jointly by sales and costs, and because 
changes in either or both will cause changes in profit, an informative 
interim report should disclose details of sales and costs. Since they are 
a necessary criteria for seeing profit levels and their changes in 
context, sales are a logical starting point for estimating future results 
of the entity, especially if probable market trends are known. They are 
also an objective and neutral measurement of activities during any 
period, and accordingly their inclusion is likely to be equally as 
valuable as details of interim profits. For these reasons, sales were 
given equal ranking with profits, that is, a maximum of nine points. 
Costs, especially changes in costs, are frequently important to an 
understanding of profit changes, for example, the introduction of 
equal pay legislation or a change in the rate of payroll tax can dras- 
tically influence profits, particularly of firms whose profits are 
subject to price control. In the interim period, management probably 
has some ability to influence the reported costs, such as by inven- 
torying an advertising campaign, or by deferring or accelerating 
repairs and maintenance. Costs are a less objective indicator of the 
interim periods' activity than sales and were accordingly weighted 
less. A maximum of six points was allocated to cost information. The 
three factors mentioned — sales, costs, and profits — all relate to the 
trading results of the interim period. Also of importance is the 
financial situation at the end of the interim period. 

Balance Sheet 

A shareholder who is given material balance-sheet information, such 
as changes in issued capital or in the working capital ratio, is better 
informed. Because trading data are a better indicator of interim 
activities and results than is the balance sheet, the maximum number 
of points for balance-sheet data was set at three points. 



'Refer to research by P. Brown and J. W. Kennelly. "The Information Content of 
Quarterly Earnings: A Clarification and an Extension" quoted in P. Broun, "The 
Impact of the Annual Net Profit Report on the Stock Market." The Australian 
Accountant (July 1970): 277: also P. Brown. "Interim Reports." The Chartered 
Accountant in Australia (August 1969): 4-8. 



80 INTERNATIONAL JOURNAL OF ACCOUNTING 



Directors' Comments 

The recipient of the report, whether shareholder or professional 
analyst, is an outsider, and the financial information in the interim 
report is highly condensed (and perhaps somewhat tentative). For the 
report to achieve its full potential and for the recipient to be able to 
derive optimum benefit from the data supplied, the knowledge and 
experience of the directors are also relevant. 

Suitable comments from the board of directors, particularly where 
some comment is given to the likely outcome of the second half of the 
year, can enhance an interim report. Because as much as one half (or 
even more) of this time may have elapsed before the interim report is 
published, the results of the second six months should be estimated 
with substantial accuracy. The points allocated to directors' com- 
ments were kept the same as for balance-sheet data, that is, a maxi- 
mum of three points. 

WEIGHTING OF DISCLOSURE METHODS 

Four possible methods of disclosure were recognized for sales, costs, 
and profits. They were ( 1 ) complete and comparative, (2) ratio change, 
(3) nonquantified, and (4) no disclosure. 

Complete and Comparative 

The maxima referred to in the preceding section were allocated only 
where "complete and comparative" presentation was followed. For 
the four financial factors (including balance-sheet data), this in- 
volved the current actual figures and the actual figures for the same 
period last year (or alternatively the current actual figures plus the 
percentage change). Only if the directors commented on both the next 
six months and the probable overall result for the year were the 
maximum points allotted. 

Ratio Change 

Two-thirds of the maximum points for each factor were allocated 
where firms used the "ratio-change method" of disclosure. The 
disadvantage of this method is seen when two factors, such as sales 
and costs, are disclosed, but the result remains in doubt, for example. 
"Sales were up by 20 percent but costs rose by 25 percent." (What 
happened to profits?) The same proportion of points was allocated 
where only a summarized balance sheet was presented. Only one 
point was allocated if the directors comment only on the year's results 
and made no remarks about the second six months. 



Qualitative Evaluation of Interim Reports 81 



Nonqualified 

One-third of the maximum points was allotted to companies making 
nonqualified reference to sales, costs, or profits. Examples were "sales 
equalled expectations" or "profits are ahead of budget." The same 
proportion was allotted where only isolated balance-sheet figures 
were disclosed and where the only comment from four directors was 
on the next six months' result with no indication of the probable 
outcome for the year. 

No Disclosure 

Where no reference was made to any of the five factors, no points were 
allotted. Exhibit 2 summarizes the way in which the points were 
allocated. In assigning points to the several factors, the main objec- 
tive was to show the relative importance of each key factor rather than 
to arrive at any absolute measurement. 8 It is recognized that many 
other factors may be considered by analysts, such as the value of 
unfilled orders, or that some more sophisticated measurements may 
be made of one or the other of our key factors (directors' comments 
may have points allocated in proportion to the number of ratios 
and/or dollar amounts mentioned). These are but variations of our 
basic tool of analysis. 

Using the points in exhibit 2, the contents of the forty reports 
ranged from one to twenty-eight points (refer exhibit 3). 

QUALITY OF REPORTS 

As was mentioned earlier, the quality of a report depends on the speed 
with which it is produced and its content. If these two factors are 
weighted equally, one may propose that 

Quality = Speed plus content 

1 
or Q = — + C 
T 

that is, quality is in inverse relation to the time taken to produce the 
report but in direct relation to its content. 

Naturally, some analysts may rank one of these two factors as more 
important. For example, a "risk preferer" would prefer to receive an 
interim report as speedily as possible knowing that the data might 

8 This type of analysis of key factors was used by the Lockheed Missiles and Space 
Company in their investigations into an optimal span of control. See H. Steiglitz, 
"Optimizing Span of Control," Management Record (September 1962): 121-29. 



82 INTERNATIONAL JOURNAL OF ACCOUNTING 



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Qualitative Evaluation of Interim Reports 83 



Exhibit 3. Analysis of Forty Interim Reports 







Points 


Timeliness 




Company 


(Content) 


(Days) 


Finance industry 


Fl 


10 (-0.04) 


40 ( 1.36) 




F2 


12 ( 0.25) 


61 ( 0.15) 




F3 


27 ( 2.39) 


28 ( 3.02) 




F4 


11 ( 0.10) 


64 ( 0.00) 




F5 


11 ( 0.10) 


36 ( 1.81) 




F6 


8 (-0.33) 


55 ( 0.46) 


Service industry- 


SI 


8 (-0.33) 


68 (-0.15) 




S2 


4 (-0.90) 


65 ( 0.00) 




S3 


3 (-1.04) 


79 (-0.45) 




S4 


6 (-0.61) 


77 (-0.45) 




S5 


27 ( 2.39) 


81 (-0.45) 


Trading industry 


Tl 


22 ( 1.68) 


56 ( 0.30) 




T2 


6 (-0.61) 


35 ( 1.96) 




T3 


6 (-0.61) 


49 ( 0.75) 




T4 


2 (-1.19) 


46 ( 0.90) 




T5 


12 ( 0.25) 


59 ( 0.15) 




T6 


12 ( 0.25) 


78 (-0.45) 




T7 


12 ( 0.25) 


37 ( 1.96) 


Conglomerate 


CI 


5 (-0.76) 


81 (-0.45) 


industry 


C2 


11 ( 0.10) 


58 ( 0.30) 




C3 


2 (-1.19) 


70 (-0.15) 




C4 


19 ( 1.25) 


56 ( 0.30) 




C5 


18 ( 1.11) 


40 ( 1.36) 




C6 


12 ( 0.25) 


38 ( 1.66) 




C7 


11 ( 0.10) 


89 (-0.60) 




C8 


17 ( 0.96) 


33 ( 2.26) 




C9 


16 ( 0.82) 


61 ( 0.15) 


Manufacturing 


Ml 


5 ( 0.76) 


88 (-0.60) 


industry 


M2 


9 (-0.18) 


50 ( 0.60) 




M3 


5 (-0.76) 


70 (-0.15) 




M4 


7 (-0.47) 


60 ( 0.15) 




M5 


1 (-1.33) 


61 ( 0.15) 




M6 


1 (-1.33) 


59 ( 0.15) 




M7 


6 (-0.61) 


51 ( 0.60) 




M8 


8 (-0.33) 


115 (-1.06) 




M9 


1 (-1.33) 


140 (-1.21) 




M10 


8 (-0.33) 


66 ( 0.00) 




Mil 


7 (-0.47) 


76 (-0.30) 




M12 


15 ( 0.68) 


49 ( 0.75) 




M13 


28 ( 2.54) 


81 (-0.45) 



1. Points were calculated according to exhibit 2. 

2. Timeliness shown is the number of days from the end of the half year to the date on which the 
report was issued. 

3. Standardized measurements are shown in parenthesis. 



84 INTERNATIONAL JOURNAL OF ACCOUNTING 



well be only tentative and not quantified; a "risk averter," on the 
other hand, would prefer to wait until more accurate information 
became available. 

The risk preferer's quality function is likely to be in the form of 

1 
Q=x— + (1 - x) C where x < 0.5. 

and the risk averters' quality function is likely to be in the form of 



Q=x— +(l-x)C where x > 0.5. 

For our analysis, we maintained equality of speed and content, 
replacing 1 T by S to designate speed so that 

Q = S + C. 

STANDARDIZATION OF MEASUREMENT 

To facilitate interindustry comparisons, we decided to standardize the 
measurements of content and speed so that the mean and standard 
deviation of each industry could be compared with the total surveyed. 
For convenience, we standardized the observations so that the total set 
of all observations, for both speed and content, had a mean of zero and 
a range of ± 0.5. Therefore, quality itself had a mean of zero and a 
range of ± 1.0. Exhibit 3 reports the standardized measurements 
alongside the raw data. Exhibit 4 indicates the standardization 
measures of quality for the five industry groups analyzed. 

The finance industry was characterized by very speedy reporting 
and high content in reports. This resulted in the high mean value for 
quality. Finance companies showed the least relative dispersion 
about their mean. The industry leader published an audited set of 
accounts twenty-eight days after the end of the half year. The results 
shown support the assumption that an up-to-date information sys- 
tem is the lifeline of the finance industry in particular. 

Service industry reports were of a much lower quality than were 
finance (Q = -0.40 compared with +1.55) and had a large relative 
dispersion (V = 305.2 compared with 1 19.7). Any major reason for the 
slowness of reporting by this group is difficult to pinpoint. It is 
unlikely to have been caused by difficulties, such as stocktaking, 
because trading companies were on average quicker reporters than 
service companies. 



Qualitative Ei'aluation of Interim Reports 85 



Exhibit 4. Summary of Measures of Quality of Interim Reports 
(in Standardized Units) 







Standard 








Mean 


deination 


Coefficient 




a 


a 


of 


variation 


Finance 


1.55 


1.85 




119.7 


Services 


-0.40 


1.22 




305.2 


Trading 


0.80 


0.96 




120.3 


Conglomerates 


0.83 


1.52 




183.4 


Manufacturing 


-0.35 


1.17 




337.1 



Trading companies had relative dispersion about this mean simi- 
lar to finance companies, but the mean quality of their reports was 
lower (Q = 0.80 compared with 1.55). Marginally better in quality 
were the reports from conglomerate companies (Q = 0.83), but these 
reports showed a much greater dispersion about their mean (vo = 
184/4). 

Very low quality reports were issued by the manufacturing indus- 
try where the mean was -0.35. The greatest relative dispersion was 
also found here. The low quality of reports from the manufacturing 
and service industries raises the question of whether there is greater 
independence from the share market. In other words, do manufactur- 
ing and service companies have a pattern of infrequent equity issues 
in the share market? If so, does this result in a different attitude toward 
timely disclosure of financial information? Intuitively, this seems 
probable. In many manufacturing concerns, the opportunities for 
piecemeal expansion are limited and the capital expenditure func- 
tion is discontinuous, unlike expansion in the trading industry where 
many firms have expanded by continual acquisition of other small 
trading units. 

When one compares the operations of the manufacturing industry 
with those of the finance industry, one can more readily see that there 
is a greater need for finance companies to be attentive to the market 
with a regular flow of information if the finance company is to 
remain in a competitive position for further reinvestment of funds 
from the public. On the other hand, provided that a manufacturing 
company regularly services its existing debt and prudently ploughs 
back sufficient earnings, there is less need to report swiftly and in 
detail the results of a period since these will not have any immediate 
effect on finances available to the manufacturing company. Because 



86 INTERNATIONAL JOURNAL OF ACCOUNTING 



of the nature of the questionnaires, it was not possible to pursue this 
line of thought in any further detail. 

CONCLUSIONS 

Given that for most companies the content of interim reports must be 
less detailed than annual reports, we believe that exhibit 2 is a 
practical method of recognizing the relative importance of five factors 
which contribute to an informative report and the manner in which 
they are reported. We see little benefit in attempting to quantify a 
quality-function equation for "risk preferers" and "risk averters" at 
this stage. Indeed, after reading G. G. Blakely's comments on the 
irrationality of investors, 9 we question the wisdom of any form of 
logical investigation into business activities. Accepting a one-for-one 
trade off of content and speed, our research showed widely varying 
standards of reporting. Leading industry groups were finance, followed 
by conglomerates and trading. Manufacturing and services showed 
very low quality reports on the average, although within each group 
there were one or two companies which did produce reports of high 
quality. 

The existence of such industry leaders prompts the thought that the 
management in such firms appears to have a different attitude toward 
disclosure and may place greater-than-average reliance on an up-to- 
date accounting system. One could speculate that such firms are 
rapidly expanding and actively pursuing a definite development 
program. An analysis of the reports of such companies over a series of 
years to establish whether there existed any perceptible change in the 
quality of their reports would be interesting. 

The methods of analysis of interim reports used here permit such 
time series analysis. Interim reports will undoubtedly change from 
year to year as new requirements become mandatory or appropriate. 
If the quality of interim reports is to be improved, then there is a need 
for a consistent and logical method of appraisal to be applied. We 
believe that the tool we have developed fulfills such a need. 

9 G. G. Blakely, "The Naked Investor, A Study in Non-Reason," The Investment 
Analyst (May 1972): 21-27. 



Financial Statement Disclosure and Corporate Law: 
The Canadian Experience 

GEORGE J. MURPHY* 



The changes that have taken place over time in Canada relating to the 
financial statement disclosure requirements of Canadian corporate 
law have had a variety of sources of influence. These influences have 
come from both England and the United States as well as from within 
Canada. Canadian legislation has at times been ahead of and at other 
times lagged behind English and American legislation. The purpose 
of this paper is to chronicle the changes in legislated financial 
statement disclosure requirements and to indicate, where possible, 
the source of the influences which gave rise to those changes. The 
evolution will be seen to reflect the English and American influences 
but have found a uniquely Canadian resolution — one which may 
have important implications for the profession in Canada. 

Apart from the relevant incorporating statutes and regulations, 
evidence for the study was sought in legislative debates, proceedings 
of governmental committe hearings, briefs and submissions made by 
various parties to committees of enquiry, and in the considerable 
professional, academic, and financial literature. Since the provincial 
Ontario legislation has tended to lead the federal Canadian legis- 
lation, both jurisdictions were examined. 



•George J. Murphy is professor of accounting at the University of Saskatchewan, 
Saskatoon, Canada. Some of the material for this paper is drawn from the author's 
Working Paper Number 20 of the Academy of Accounting Historians, "The Evolution 
of Corporate Reporting Practices in Canada." The author wishes to thank his 
colleagues. Professors G. Baxter, W. J. Brennan, V. G. Irvine, and D. Lindsay, for their 
helpful comments. 



INTERNATIONAL JOURNAL OF ACCOUNTING 



1877 TO 1917 



On the federal Canadian level, the first disclosure provision requiring 
that "... directors of every company lay before its shareholders a full 
and clear printed statement of the affairs and financial position of the 
company at or before each general meeting . . ."' was enacted in 1877. 
The more specific requirement that such statements be presented 
annually was incorporated in the 1902 Act. 2 Many federally in- 
corporated companies, prior to the mandatory presentation of the 
profit and loss statement in the legislation of 1917, interpreted these 
provisions as applying only to the balance sheet. 3 

Ontario has been the center of commercial and financial activity in 
Canada, and it is therefore not surprising to find its legislation well 
ahead of the federal jurisdiction. The Ontario legislation of 1907 and 
1953 are outstanding examples of this leadership. Even the earliest 
provincial legislation of 1897 seemed to anticipate the modern em- 
phasis of the income statement over the balance sheet by requiring the 
preparation of a statement of "income and expenditure." 4 Indeed, an 
audited balance sheet was to be presented at the annual meeting only 
if the by-laws of the company so directed. The Ontario Companies 
Act of 1907, in addition to requiring the statement of income and 
expenditure and the audited balance sheet, specified certain dis- 
closures relating to the balance sheet. 5 These provincial requirements 
are detailed in exhibit 1 because with respect to the provision of the 
income statement and the detail to be included in the balance sheet, 
they are the earliest significant corporate disclosure requirements of 
any English, American, or Canadian jursidiction. With additional 
requirements relating to disclosure of values received for shares issued 
and of amounts amortized in respect to fixed assets and goodwill, the 
1917 federal legislation 6 is a direct copy of the 1907 Ontario 
provisions. 

An understanding of the reasons for the early prominence of 
Canadian legislation is not wholly complete. The inspiration of the 
1907 Ontario legislation is attributed to the recommendations of the 
Institute of Chartered Accountants of Ontario by T. Mulvey, who had 
been both the federal under secretary of state and the Ontario assistant 



'Canada. Statutes, Canada Joint Stock Companies Act, 1877, 40 Vict., rh. 43, sec. 87. 
2 Canada, Statutes, The Companies Act, 1902, 2 Edward VII, ch. 15, sec. 88. 
3 See, for example, various annual anthologies of financial statements in The Annual 
Financial Review — Canadian (Toronto: Houston's Standard Publications 1901-1916). 
^Ontario, Statutes, The Ontario Companies Act, 1897, 60 Vict., ch. 28, sees. 75 and 84. 
5 Ontario, Statutes. The Ontario Companies Act, 1907, 7 Edward VII, ch. 34, sec. 36. 
6 Canada, Statutes, The Companies Act Amendment Act, 1917, 8 George V, ch. 25, sec. 
105. 



Canadian Financial Statement Disclosure 89 



Exhibit 1. Financial Statement Disclosure Requirements 
of the Ontario Companies Act, 1907 

At such meeting the directors shall lay hefore the company 

a) A balance sheet made up to a date not more than three months before such 
annual meeting. 

b) A statement of income and expenditure for the financial period ending 
upon the date of such balance sheet. 

c) The report of the auditor or auditors. 

The balance sheet shall be drawn up so as to distinguish at least the 
following classes of assets and liabilities, namely: 

a) Cash; 

b) Debts owing to the company from its customers; 

c) Debts owing to the company from its directors, officers and shareholders; 

d) Stock in trade; 

e) Expenditures made on account of future business; 

f) Land, buildings and plant; 

g) Goodwill, franchises, patents and copyrights, trademarks, leases, con- 
tracts and licenses; 

h) Debts owing by the company secured by mortgage or other lien upon the 

property of the company; 
i) Debts owing bv the company but not secured; 

J)* 

k) Amount received on common shares; 
1) Amount received on preferred shares; 
m) Indirect and contingent liabilities. 

*No entrv for j) is given in the original an. 

provincial secretary. 7 The Institute recommendations may well have 
drawn on the extensive optional disclosure requirements in the 
model articles, Table B, of the English Act 8 of 1856 and on the 
suggestions of the committee that made recommendations for changes 
in the English Act 9 of 1900. (Hatfield has acknowledged the signifi- 
cance of the model articles on American practices.) 10 Though the 
Engish Act of 1900 required a mandatory audit, 11 there was require- 
ment neither for the provision of an income statement nor for any 
minimum details to be included in the balance sheet. The English Act 
of 1908 put forward only the very general requirement that a balance 

7 T. Mulvey, Dominion Company Lam (Toronto: The Ontario Publishing Co.. 1920). 
p. 54. 

8 Great Britain, Statutes, Joint Stock Companies Act, 1856. 19 and 20 Vict., ch. 47. 
9 H. C. Edey and Prot Panitpakdi, "British Company Accounting and the Law 1844- 
1900," in Studies in the History of Accounting, ed. by A. C. Littleton and B. S. Yamey 
(London: Sweet and Maxwell, 1956), p. 374. 

10 H. R. Hatfield. "Variations in Accounting Practice." Journal of Accounting Re- 
search (Autumn 1966): 172. 
"Great Britain, Statutes, Companies Act, 1900, 63 and 64 Vict., ch. 48. 



90 INTERNATIONAL JOURNAL OF ACCOUNTING 



sheet, showing ". . . such particulars as will disclose the general 
nature of these liabilities and assets, and how the values of those fixed 
assets have been arrived at," must be forwarded to the Registrar of 
Companies. 12 

Sources of influence from within Canada are various. The Institute 
of Chartered Accountants of Ontario is likely to have had a strong 
self-interest in the mandatory audit provisions of the 1907 act. Revela- 
tions of the Royal Commission on Insurance 13 had alerted the finan- 
cial community to abuses in corporate accounting practices. Similarly, 
the Ontario Conservative government of J. P. Whitney was certainly 
of a disposition to constrain the corporate "laissez-faire" attitudes of 
the day. 14 

At the federal level, several factors were influential in the promul- 
gation of the 1917 Act: the concern for mergers and the profit in 
corporate promotions, 15 the rash of bankruptcies at the beginning of 
World War I, 16 the bank failures culminating in the bank legislation 
of 1913, n and the existence of a pattern for legislation in the Ontario 
Act 18 of 1907. Very likely, however, the single most immediate reason 
for the 1917 Act was the imposition of the Tax Acts of 1916 19 and 
191 7. 20 The mandatory audit provisions and the minimum disclosure 
requirements would provide a more consistent and comparable base 
upon which taxes could be levied. "Taxation equity" would also be 
satisfied by having a respected professional attest to the adequacy of 
financial statement disclosure. The complementary nature of the 
1916-17 Tax Acts and the 1917 audit and disclosure provisions is 
implicit in several commentaries of that time. 21 No additional evi- 
dence was uncovered from any source — the financial press, legislative 

12 Great Britain. Statutes. Companies (Consolidation) Act. 1908. 8 Edward VII, ch. 69. 
13 Canada. Royal Commission on Life Insurance 1907 (Ottawa: King's Printer, 1907). 
'■•Witness the mining legislation, the formation of the publicly owned Hydroelectric 
Power Corporation and the government intervention in the bankruptcy of the Con- 
solidated Lake Superior Company. C. W. Humphries, "The Political Career of Sir 
James P. Whitney" (Ph.D. Dissertation. University of Toronto, 1966), pp. 301-410: and 
J. Schull, Ontario Since 1867 (Toronto: McLelland and Steward, 1978), pp. 125-78. 
15 A. Raynatdd. The Canadian Economic System (Toronto: Macmillan Company of 
Canada, 1967). 149-50; and O. D. Skelton, General Economic History of the Dominion 
1867-1912 (Toronto: Publishers Association of Canada, 1913). pp. 259-61. 
16 M. C. I'rquhart and K. A. Buckley, eds., Historical Statistics of Canada (Toronto: 
Macmillan Company of Canada. 1965), p. 659. 
1? Canada, Statutes, The Bank Act, 1913, 3 and 4 George V. 
l8 Mulvey, Dominion Company Law, p. 54. 

19 Canada, Statutes, Business Profits War Tax Act, 1916, 6 and 7 George V. 
20 Canada, Statutes, The Income War Tax Act, 1917, 7 and 8 George V. 
21 See for example. Canada, House of Commons Debates, vol. 6. 1917, p. 5937: and J. 
Parton, "Merchandise Inventories and the Auditor's Responsibility Therefor," 
Canadian Chartered Accountant (October 1917): 99. 



Canadian Financial Statement Disclosure 91 



debates, economic and legal histories, or accounting literature exist- 
ing in The Canadian Chartered Accountant — to indicate why this 
audit and disclosure legislation was passed at a time when the efforts 
of the whole country were devoted to the war. At the annual meeting 
in 1918, the president of the Canadian Institute drew attention to the 
passage of the act but made no further comment. 22 

1917 TO 1935 

The noteworthy legislation in this period occurred at the federal level 
in 1934 23 and 1935. 24 Mandatory income statement disclosure related 
to directors' and executive officers' fees and salaries, depreciation, 
taxes, investment income, nonrecurring profits and losses, amortiza- 
tion of any asset, and interest on long-term debt. The transactions in 
the various surplus accounts must be disclosed and their year-to-year 
reconciliation demonstrated. Balance-sheet disclosure must include 
the valuation basis of receivables, investments and marketable secu- 
rities, inventories, land, buildings and plant, and, if the fixed-asset 
valuation is based on appraisal, the date of the appraisal and the 
name of the appraiser. The preparation of consolidated statements, 
though long since used in practice, was now officially permitted. 
Where consolidated statements were not prepared, the investment in 
the shares of, and loans to, subsidiaries must be disclosed together 
with the treatment of their aggregate profits and losses. 

Internal influences were likely of greatest importance on the 1934- 
35 Canadian legislation. Little concern for increased disclosure was 
evident during the 1920s when economic events were buoyant; how- 
ever, with the fall in values relating to the stock market crash of 1929 
and the depression of the 1930s, the Canadian public began to clamor 
for more information. The highly respected Professor R. G. H. 
Smails 25 and a study group of Queen's University professors 26 called 
for improved disclosure. Financial commentary, particularly The 
Financial Post, added to the clamor. 27 The immediate stimulus 28 for 



22 J. Hyde, "The President's Address," Canadian Chartered Accountant (October 1918): 

93-103. 

"Canada, Statutes, Companies Act, 1934. 24 and 25 George V, ch. 33. 

"Canada, Statutes, Companies Act. 1935, 25 and 26 George V, ch. 33. 

25 R. G. H. Smails, "Directors' Reports— A Criticism and Suggestion," Canadian 

Chartered Accountant (September 1931): 101-3. 

26 Members of the Department of Political and Economic Science at Queen's University, 

"Financial Manipulation: A Project of Reform," Queen's Quarterly (May 1933): 274- 

77. 

""Audit Responsibility Urged in 1932 Statements," Financial Post (21 January 1933), 

p. 11. Aho see Financial Post (24 June 1933), p. 12; (16 December 1933). p. 11, and (6 

May 1933), p. 11. 

28 See Canada, Senate Debates (1934), p. 452. 



92 INTERNATIONAL JOURNAL OF ACCOUNTING 



the 1934 legislation was provided by the Conference of Commis- 
sioners on Uniformity of Legislation which had prepared draft 
legislation. Though reporting practices clearly needed improvement, 
most of the incentive for the legislation came from a need to correct 
abuses in corporate promotion and capitalization. 29 In 1931, the 
Canadian Institute of Chartered Accountants made proposals for 
uniform legislation relating to financial statements and also made a 
submission to the federal government for the 1934 legislation. 30 

Though the English Companies Act 31 of 1928 made mandatory the 
provision of an income statement, very little minimum disclosure 
was required in the financial statements beyond the need to specify 
directors' fees, the nature of the valuation of fixed assets, the treatment 
of subsidiary profits and losses, and the amount transferred to reserve 
accounts. It was only with respect to these last four items that the 1928 
English legislation was in advance of the 1907 and 1917 Canadian 
legislation. The latter, on the other hand, required much more 
detailed information in the balance sheet than that of the English 
legislation. The 1934-35 Canadian legislation, as previously out- 
lined, far exceeded the 1928 English legislation. Indeed, the pro- 
visions relating to the disclosure and reconciliation of surplus ac- 
counts were incorporated into Canadian law to remedy some of the 
English Act's deficiencies 32 — deficiencies that may well have per- 
mitted the 1929-30 English Royal Mail Steam Packet Scandal to 
occur. The differences in Canadian and English requirements are 
discussed at length here to dispel the general misbelief that, up to this 
time, the Canadian financial statement disclosure legislation was a 
mere copy of that of the English. While many aspects of the corporate 
audit provisions had indeed been copied from English legislation, the 
Canadian disclosure requirements were well ahead of their English 
counterparts. 

Though no evidence was uncovered to demonstrate the specific 
effect of American influence on the Canadian legislation, there were 
many signs portending America's future pervasive influence on 
Canadian thought and practices. American theory and practices in- 
cluding Uniform Accounting (1917) and Verification of Financial 



29 W. A. Macintosh, "Economics and Accountancy," Canadian Chartered Accountant 
(December 1932): 407. See also J. L. Ralston, "Discussions on Dominion Companies 
Act," Canadian Chartered Accountant (February 1935): 87; and Canada, House of 
Commons Debates (29 May 1934), pp. 3454-58. 
30 Neither report could be located by the writer. 

31 Great Britain, Statutes, Companies Act, 1928, 18 and 19 George V, ch. 45. 
32 R. G. H. Smails, "Students' Department," Canadian Chartered Accountant (Sep- 
tember 1934): 283. 



Canadian Financial Statement Disclosure 93 



Statements (1929) were carefully reported on and extolled in the 
Canadian literature. 33 Professor Smails of Queen's University, a 
member of the Institute of Chartered Accountants in England and 
Wales, went so far as to recommend American texts as being theoret- 
ically superior to those of the English. 34 It is, however, quite likely 
that similar events in both America and Canada — stock promotion 
abuses and financial reporting inadequacies — gave rise to the vir- 
tually coincident 1934-35 Canadian and 1933-34 American legislation 
and that the Canadian legislation can therefore be explained without 
reference to the United States. In America, government intervention 
may have come as a sudden jolt, but in Canada, the vehicle of 
correction, the Companies Acts, had existed for many years and 
undoubtedly, by contrast, the 1934-35 legislation can be regarded as 
an evolution rather than a revolution. 

1935 TO 1953 

The Ontario Corporation Act 35 of 1953 constituted the first signifi- 
cant revision of that province's legislation since 1907. It is of major 
importance in the Canadian geneology because the disclosure pro- 
visions are so recognizably modern. They were virtually written by 
the Institute of Chartered Accountants of Ontario. 36 Once again, they 
were the direct model for the federal legislation which was to appear 
ten years later. The additional disclosure requirements related to the 
provision of much more informational detail in the income and 
retained earnings statements, the balance sheet, and the financial 
statement footnotes. Restrictions were placed, as well, on the wording 
and treatment of the various surplus and reserve accounts. 

Apart from laying the foundations for modern disclosure require- 
ments in Canada, this Ontario legislation is particularly interesting 
because of its inspiration. Though there was some concern 37 for 
improving the federal 1934-35 and particularly the 1907 Ontario 
provisions, 38 there were no important instances of business scandals 



33 G A. Clapperton, '"The Balance Sheet," Cost and Management (July 1927): 10. 
34 R. G. H. Smails, "Students' Department," Canadian Chartered Accountant iMa\ 
1935): 367. 

"Ontario, Statutes, The Corporations Act, 1953, I Eliz. II, ch. 19. 
36 J. G. Glassco, "Accounting in a Modern World." Canadian Chartered Accountant 
(April 1955): 212. Glassco was president of the Canadian Institute in 1955. 
37 See, for example: W. G. Leonard, "A Plea for Greater Frankness in Financial 
Representations," Canadian Chartered Accountant (July 19-42): 12-13; C. A. Ashley. 
"Uniform Accounting," Commerce Journal (April 1943): 1-9; W. F. A.Turgeon.ftoytf/ 
Commission on the Textile Industry (Ottawa: King's Printer, 1938), p. 127. 
38 R. G. H. Smails. "Students' Department," Canadian Chartered Accountant (Sep- 
tember 1943): 197. 



94 INTERNATIONAL JOURNAL OF ACCOUNTING 



or corporate malfeasance to fan the flames of change as happened 
with the 1934-35 legislation. The author's conjecture that the legisla- 
tion took place first because the provincial statutes had not been 
revised since 1907 and were now well behind the federal legislation, 
and second, because the model for revised disclosure had already been 
framed in the Canadian Institute of Chartered Accountants' Bulletin 
No. 1, is confirmed by the then secretary to the Select Committee on 
Company Law. 39 The secretary also indicated that the enquiry and 
revision were made possible at that particular time because 

the number of members of the House of the government party far exceeded the 
total number of members in the opposition parties and the use of the Select 
Committee gave Mr. Frost (the Premier of Ontario) an opportunity of 
keeping many of his backbenchers actively employed, especially between 
sessions when most of the work of the Select Committee was done. 

The 1953 legislation illustrates the increasing influence of the 
Institutes of Chartered Accountants. The disclosure provisions of 
that Act were a virtual copy of the recommendations of the Ontario 
Institute to the Select Committee. 40 These recommendations were, in 
turn, based wholly on the Canadian Institute's first bulletin on 
recommended disclosure standards in 1946. 41 The substantive author- 
ship of this bulletin is attributed to the Committee on Accounting 
and Auditing of the Ontario Institute. 42 

As English influence continued to wane in importance, American 
influence tended to increase. The disclosure provisions of the English 
Act 43 of 1947 went little beyond the 1934-35 Canadian legislation. 
However, the accounting standards and guidelines of the Securities 
and Exchange Commission (SEC) following 1935 and those of the 
American Institute commencing in 1939 were well ahead of Canadian 
thought and practice 44 and were invariably repeated and commented 
on favorablv in The Canadian Chartered Accountant. The close 



39 S. Lavine, in correspondence with the author, dated 10 June, 1970. 
40 The Special Committee of the Legislature of the Province of Ontario charged with 
the Revision of The Companies Act (Ontario) and Related Acts, Proceedings, vol. 15 
(Oct. 6, 1952). 

41 A Statement of Standards of Disclosure in Annual Financial Statements of Manu- 
facturing and Merchandising Companies, Bulletin #1 (Dominion Association of 
Chartered Accountants. 1946). 

42 J. R. M. Wilson, "Standards of Disclosure" (Address to Dominion Association of 
Chartered Accountants. Montreal. 11 September 1946). 

•"Great Britain. Statutes, The Companies Act, 1947. 10 and 11 George VI. ch. 47. 
44 See, for example, SEC Accounting Series Release Xo. 7, "Analysis of Deficiencies 
Commonly Cited by Commission in Connection with Financial Statements" (May 
1938), reprinted in Federal Securities Law Reports (Washington: Commerce Clearing 
House, undated). 



Canadian Financial Statement Disclosure 95 



relationships between many American and Canadian professional 
accounting firms also served to highlight disclosure differences be- 
tween the two countries. 45 The vehicle for this influence now became 
the Canadian Institutes as they carefully screened American thought 
and practices before making their own recommendations. Canadian 
commentators at times envied the incentive provided in America by 
the existence and activity of the SEC. 46 

1953 TO PRESENT 

The most notable legislation of the 1960s was the Canada Corpora- 
tions Act 47 of 1964-65 and the Ontario Securities Act 48 of 1966. The 
federal legislation initiated by the Senate 49 is, with a few additions, 
almost identical to the 1953 Ontario legislation. Though there were 
increasing signs of dissatisfaction with the inadequacies of corporate 
reporting, 50 neither the provincial nor federal legislation was the 
result of widespread notoriety or discontent. Senate debates ac- 
knowledged that the 1934-35 legislation was simply out of date and 
that the revision was copied from the existing Ontario legislation. 51 
Similarly, the Kimber Committee 52 which made recommendations 
for the Ontario Securities Act changes was established not because of 
any particular grievance or scandal, but rather because of a concern 
that the law was in need of review. 53 Following the Kimber Report, 
the Ontario Securities Act was drastically revised, giving ongoing 
surveillance of Canada's chief exchange, the Toronto Stock Ex- 
change, to the Ontario Securities Commission. Though this com- 
mission holds powers at the provincial-listed security level similar to 
those of the American SEC, 54 it has not created an elaborate financial 
statement review process, nor has it attempted to promulgate its own 
accounting guidelines. 55 

45 Howard Ross, of Touche Ross &r Co., in correspondence with the author dated 21 
August 1972. 

46 Glassco, "Accounting," p. 212. 

"Canada, Statutes, Canada Corporations Act, 1964-1965, 13 and 14 Eliz. II, ch. 52. 
"Ontario, Statutes, The Securities Act, 1966, 14 and 15 Eliz. II. ch. 142, Part XII. 
49 Senate of Canada, Proceedings of the Standing Committee on Banking and Com- 
merce, 26 Pari., 1964. 

50 In response to which the Canadian Institute issued the first of its recommended 
standards on disclosure. Bulletin No. 1, in 1946. 
51 Canada. Senate Debates (1964). pp. 515-18. 

52 Attorney General of Ontario, Report of the Attorney General's Committee on 
Securities Legislation in Ontario (Toronto: Queen's Printer, 1965). 
53 J. R. Kimber, in correspondence with the author, dated 3 July 1970. 
54 See Ontario, Statutes, The Securities Act, 1966, 14 and 15 Eliz. II, sec. 139, Part XIV. 
"Some exceptions do exist. See "Recognition of Profits in Real Estate Transactions." 
Ontario Securities Commission Bulletin (Toronto: Ontario Securities Commission, 
July 1969). 



96 INTERNATIONAL JOURNAL OF ACCOUNTING 



Though the federal and provincial legislation of the mid 1960s 
were not initiated by widespread dissatisfaction with corporate re- 
porting, they were preceded by a relatively quiet but fairly steady 
stream of concern. 56 That concern grew to very broad proportions 
following the mid 1960s and served to thrust the Canadian Institute 
into a position of great prominence. The American influence which 
was acknowledged in the Kimber Report's recommendations con- 
tinued as Canadians closely observed the many aspects of American 
accounting practice that were being publicly questioned during 
this period. 

A financial failure of significant proportions — the Atlantic Ac- 
ceptance Company 57 — in 1965 is likely a turning point in the attitude 
of the public and the financial community with regard to corporate 
regulation and financial disclosure requirements. From this time 
onward, governments and boards of enquiry seemed increasingly 
willing to respond to what were felt to be corporate shortcomings. 
The Atlantic Acceptance failure brought into question, among other 
things, the appropriateness of loans to affiliated companies, income 
reporting practices of financial institutions, and parent auditors' 
responsibility with regard to the subsidiary auditor's work. This 
failure, together with a rash of other major financial corporate crises, 58 
spurred a concern for reform at many levels. 59 The concern for 
improved disclosure was accompanied by an increasing demand for 
narrowing the range of acceptable accounting practices. 60 Principles 
and standards as well as increased disclosure were now being 
demanded. 



56 See the Report of the Royal Commission on Banking and Finance (Ottawa: Queen's 
Printer, 1964). pp. 350, 560-61; and the Report of the Attorney General's Committee on 
Securities Legislation m Ontario (Toronto: Queen's Printer. 1965). p. 7. 
"Ontario Lieutenant Governor in Council. Report of the Royal Commission Ap- 
pointed to Enquire into the Failure of Atlantic Acceptance Company Limited (Toronto: 
Queen's Printer. 1969). 4 volumes. Note Mr. Justice Hughes' impatience at the 
slowness of the accounting profession in resolving issues, pp. 1589-90. 
5fi For example, British Mortgage and Trust, Alliance Credit Corporation, Prudential 
Finance Corporation. Windfall Oils and Mines Limited. Revenue Properties Ltd., 
Corporation Foncier de Montreal, and the Commonwealth group of companies 
experienced either failure or major financial crises. 

59 "Finance Company Bill Arousing Business' Ire," Financial Times (2 December 
1968), p. 3. 

60 See E. C. Harris, "Access to Corporate Information." in Studies in Canadian Com- 
pany Law, ed. J. S. Ziegel (Toronto: Butterworths, 1967), p. 491: also R. H. Jones, "Do 
Those Financial Statements Really Inform the Shareholder?" Financial Post, (18 
September 1965). p. 13; and the Director of Research of the Canadian Institute G. 
Mulcahy, The Auditor's Report on Consolidated Statements." Canadian Chartered 
Accountant (April 1966): 288. 



Canadian Financial Statement Disclosure 97 



Modest alterations were legislated in the Ontario Corporations 
Act 61 of 1970. It was, however, the Canadian Securities Administra- 
tors 62 in 1972, the Canadian Business Corporations Act 63 in 1975, and 
the Ontario Securities Act of 1978 64 that proposed the boldest legisla- 
tive requirement in response to perceived disclosure and uniformity 
inadequacies. National Policy No. 27 of the Canadian Securities 
Commissions indicates that the Canadian Institute Handbook must 
be used to determine what constitutes generally accepted accounting 
principles. Greater ease and flexibility in making changes in finan- 
cial statement requirements are provided in the Canada Business 
Corporations Act and the Ontario Securities Act by relegating such 
matters to the Regulations. These Regulations similarly require that 
financial statements be prepared in accordance with the Handbook. 
Only with respect to the reporting of diversified operations does the 
federal legislation go beyond Handbook requirements. 65 

The accounting profession has moved from a pleading or advocacy 
position to a legislative position. Henceforward, the recommenda- 
tions of the Institute Handbook are the law of the land. This startling 
result had little, if any. debate or discussion in the professional 
literature, though some foreshadowing was evidenced in 1971 in 
Proposals for a New Business Corporations Law for Canada which 
indicated that 

it should not be left to the persuasive powers of the accounting profession to 
see to the implementation of improved financial reporting practices, because 
the unscrupulous will tend to observe only the minimum legal requirements. 66 

(It was only in 1973 that the Ontario Institute's Rules of Professional 
Conduct required departures from the Handbook to be justified. 67 ) 

61 Ontario, Statutes. The Business Corporations Act, 1970, 19 Eliz. II, ch. 25. The 
Lawrence Committee had earlier indicated that "no present need had been demon- 
strated for amendments of major significance to the financial disclosure provisions of 
the Ontario Act." The Legislative Assembly of Ontario, Interim Report of the Select 
Committee on Company Law — 7967 (Toronto: Queen's Printer. 1967), par. 10.1.4. 
62 Canadian Securities Commissions. "National Policy No. 27. Generally Accepted 
Accounting Principles" (Toronto: CCH, 1972), vol. 2. 54-864. 
"Canada, Statutes. Canada Business Corporations Act, 1975. 23 Eliz. II. 
""Publications under the Regulations Act," Ontario Gazette, part II (28 July 1979). 
6b Canada Business Corporations Act Regulations (Toronto: Richard Dee Boo, 1976), p. 
189. It should be noted that a submission by the Institute succeeded in having removed 
those draft regulations which conflicted with or were redundant with the Handbook. 
See Canadian Institute of Chartered Accountants, Draft Regulations Under the Canada 
Business Corporations Act (Toronto: CICA. 1975). 

66 Proposals for a New Business Corporations Law for Canada (Ottawa: Queen's 
Printer, 1971), part 13, par. 327. 

67 See G. Mulcahy, "Ontario Institute's New Rules re Accounting Standards," CA 
Magazine (August 1973): 50. 



98 INTERNATIONAL JOURNAL OF ACCOUNTING 



The Public Accountancy Amendment Act of Ontario 68 in 1962 had 
given members of the Institute of Chartered Accountants of Ontario 
the exclusive right to the practice of public accounting in Ontario. It 
may have been only inevitable then that the Ontario Securities 
Commission, as a member of the Canada Securities Commission, 
would, when confronted with a mood for reform, look for help from 
the agency to whom a monopoly had been granted. The earlier- 
mentioned suggestion that legislation was needed to aid the per- 
suasive powers of the professional accountants may also have been 
influential in the minds of legislators and securities commissioners. 

POSTSCRIPT 

The position of the Canadian Institute and its rule-making office 
would seem to be somewhat different from that of its counterpart 
institutes in England and America. In the former country, the mini- 
mum legal requirements for disclosure continue to be set forth in the 
Companies Acts. 69 Recommendations of the English Institute are not 
acknowledged in English legislation, although undoubtedly as in 
Canada prior to the most recent legislation, Institute recommenda- 
tions would be regarded as an acceptable standard in the event of 
enquiry or litigation. 

In America, the Securities and Exchange Commission controls 
accounting practices. Though it acknowledges the pronouncements 
of the Financial Accounting Standards Board (FASB) as having 
substantial authoritative support, its on-going close surveillance of 
accounting matters, through its own releases or in the countermand- 
ing of FASB pronouncements, leaves little doubt where short-run as 
well as long-run command resides. 

From the turn of the century in Canada, the legislative authorities 
have relied heavily on the Institutes to provide the framework for 
financial statement disclosure. Since the mid-1960s, there has been an 
increasing public demand to narrow the range of acceptable account- 
ing practices as well as to provide greater disclosure. The extension of 
these trends has resulted in the formal delegation of the determina- 
tion of standards and disclosure requirements to the Institute. Insti- 
tute recommendations are now law, and the various powers within 

"Ontario, Statutes, The Public Accountancy Amendment Act, 1961-1962, 10 and 11 
Eliz. II, ch. 113. This monopoly position is now being questioned in Professional 
Regulation, the study of the Professional Organization's committee appointed by the 
attorney general of Ontario. 

69 Most recently in Great Britain, Statutes, Companies Act, 1976, 24 and 25 Eliz. II, ch. 69 
and previously in Companies Act, 1967, 15 and 16, Eliz. II, ch. 11. 



Canadian Financial Statement Disclosure 99 



securities and corporate legislation can be called upon to enforce 
compliance. 

Though the Institute seems to have warmly welcomed its new 
task, 70 it is not one without extremely heavy responsibilities. When 
power is given to determine accounting standards, the responsibility 
to undertake this task in a competent and timely fashion also follows. 
Though recourse to prior American discussion and research on many 
of the problems that would confront the Institute would be an 
invaluable aid, the burden of standard setting is likely to grow at an 
increasing rate. If insufficient resources are devoted to this task or if 
improper standards are set, or if standards for particular events or 
activities have not been set at all, the Institute bears enormous 
responsibility. To the extent that reliance on the Handbook is 
complete, the blame for a serious financial scandal that could be 
attributed to improper or inadequate standards might well redound 
directly to the discredit of the Institute. In such an event, the Institute 
might be particularly vulnerable or exposed since, unlike the Finan- 
cial Accounting Standards Board, the various committees that pro- 
pose and define standards are composed largely of volunteer members 
holding relatively short-term appointments. 71 The Institute would be 
unwise to minimize in any way the significance of the responsibility 
which it now bears. 



70 Mulcahy. "New Rules re Accounting Standards," p. 50. 

"See Canadian Institute of Chartered Accountants, "Rules of Membership and Princi- 
pal Terms of Reference of Accounting Research Committee as approved by Board of 
Governors," CICA Handbook (September 1973). 



A Comparison of Preparation for the Accounting 
Profession among New Zealand, the United Kingdom, 
and the United States 

WILLIAM MARKELL* 
INTRODUCTION 



While New Zealand, the United Kingdom, and the United States 
share a common language, English, there are many differences in 
their societies. Included in these differences is admission to many of 
the professions, and to the educational systems. Differences in the 
preparation for the accounting profession and other related aspects of 
the profession form the foundation for this paper. 

We have only to look at the recent past to find that for many years 
accountancy was practiced quite differently in various parts of the 
world. With the increasing interdependence of national economies 
and financial markets, it has become apparent that greater uniformity 
in standards of practice is required. The proliferation of multi- 
national corporations, both privately and publicly owned, is one 
facet of the growing interrelationships among the various national 
economies. As the number of multinational industrial, commercial, 
and financial institutions grew, a need for multinational firms of 
auditors and accountants was felt. Today, there are a number of 
international chartered accountant (CA)/certified public accountant 
(CPA) firms. The importance of developing common accounting 
standards has been realized and is evident in the creation of the 



•William Markell is chairperson of the Department of Accounting at the University of 
Delaware. 



102 INTERNATIONAL JOURNAL OF ACCOUNTING 



International Accounting Standards Committee. This group has 
published a number of international standards and is continuing its 
work. In addition, an international group was recently created to deal 
particularly with auditing standards. One further indication of the 
arrival of accounting as an international profession is the decision by 
one international accounting firm to transfer its headquarters from 
the United States to Switzerland. This internationalization of ac- 
counting obviously has implications for accounting education. How 
are future accountants being prepared? The purposes of the research 
project were twofold: (l)to make comparisons between university 
education for the accounting profession in the United Kingdom, the 
United States, and New Zealand, and (2) to discover how accounting 
professionals view accounting graduates from the universities. 1 

METHODOLOGY 

The information on university education for the accounting profes- 
sion in New Zealand and in the United Kingdom was obtained 
through personal interviews of accounting faculty and administra- 
tors at a number of universities as well as through a review of 
university catalogues (calendars). Views of the professionals were 
obtained in personal interviews. (The term "professional" is used in 
the broad sense to include those in public, private, and governmental 
accounting.) 

GENERAL COMPARISONS 

Before we look at the differences in university preparation for the 
professions, some background information is important. "Typical" 
American and N.Z. youngsters attend school for twelve years prior to 
entering the university, while in England the pre-university period is 
normally thirteen years. The additional year does result in some 
amount of incremental learning as is evidenced by the fact that some 
U.S. universities will accept English secondary school graduates into 
the sophomore (second) year of academic programs. Approximately 
15 percent of U.K. college-age youth actually go on to higher educa- 
tion with about half of this number attending the universities. The 
remaining half attend polytechnics and colleges of higher education. 
In New Zealand, approximately 10 percent of college-age youth 



'Ac quisition of the requisite information and opinions was facilitated by the fact that 
the writer was able to be at the University of Manchester, Manchester. England, and at 
the University of Canterbury, Christchurch, New Zealand, for substantial portions of 
the 1977-1978 academic year. 



Preparation for the Accounting Profession 103 



attend universities, while in the United States, the percentage is about 
40 percent. Admission requirements to the better U.K. universities 
appear in general to be more selective than those of similar U.S. or 
N.Z. institutions, particularly when compared to those of many U.S. 
state universities. 

An additional item of background information should be dis- 
cussed. Education at the university level for the accounting profes- 
sion dates back to the late nineteenth and early twentieth century in 
the United States, while it has been generally available in the United 
Kingdom for only about ten to fifteen years, and in New Zealand such 
education goes back almost thirty years. Accounting education in 
many universities in the United Kingdom was and is closely asso- 
ciated with departments of economics as was true in the United States 
in early days. As David Solomons has stated, ". . . accounting studies 
have suffered from a position of tutelage to departments of economics 
from which they are only now emerging. . . ." 2 Only recently have 
separate departments of accounting been established at some of the 
U.K. universities. New Zealand followed a similar pattern, and at 
present, accounting departments are generally separate units. It is the 
writer's opinion that, in some cases in the United Kingdom, the 
faculty teaching accounting are trying to "prove" that accountancy is 
as worthy of being included in university curricula as are many more 
established disciplines. This does much to explain why accounting as 
taught in many U.K. universities is highly conceptual with scant 
attention given to more practical or "how to do" aspects. In general, 
N.Z. and U.S. accounting programs attempt to blend theory with the 
more mechanical aspects. 

EDUCATIONAL SYSTEMS 

The comparison presented here is limited to the preparation offered 
at the undergraduate level by universities. In the three countries, 
accounting education is offered by institutions other than universities 
and is also offered at the graduate level, but these are not included in 
this study. 

In the United States, the normal undergraduate program in the 
more than 500 colleges which offer accounting requires four years of 
full-time academic study. There appears to be more diversity among 
the six N.Z. universities. In four of the universities, three vears of 



2 Prospectus for a Profession — The Report of the Long Range Planning Enquiry into 
Education and Training for the Accountancy Profession (London: Sullivan, 1974), p. 
39. 



104 INTERNATIONAL JOURNAL OF ACCOUNTING 



instruction are needed to meet the requirements of the New Zealand 
Society of Accountants as well as to complete the formal education. 
Another university has a four-year degree, and in the sixth, a three- 
year degree is given, but a student would then attend for a fourth year 
to meet the professional educational requirements. It is interesting 
that the newest of the universities was able to initiate a four-year-degree 
program while others have been prevented from extending the ac- 
counting degree for a fourth year. 

Accounting education in the United Kingdom normally takes three 
years, with a four-year degree being possible for honor students in 
Scotland. Attendance at a university for four years instead of three is 
not in itself inherently positive (or negative) except for allowing some 
individuals another year in which to mature. The quality of the 
fourth year depends on the use to which the time is put. The vast 
majority of U.S. universities requires students to take at least 40 
percent of their work in the "liberal arts" and another 25 percent in 
the "business core." (See the discussion in the following section.) 

CURRICULUM 

Comparison of different universities is difficult at best since normally 
the only information available is the titles of courses and brief 
descriptions. Curricula in the United States, the United Kingdom, 
and New Zealand can only be compared in a general way since it is 
unlikely that any two universities in any country will have exactly the 
same requirements. The degree requirements for someone majoring 
in accountancy varies considerably among the six N.Z. universities. 
In the United States, there are also differences among the over 500 
institutions of higher education offering undergraduate accounting 
programs. 

Although these difficulties do exist, accounting education in the 
countries can be compared in general terms. Schools in the United 
States generally divide the academic year into two semesters or three 
quarters, while in New Zealand and the United Kingdom most 
schools give courses for an entire academic year. One of the N.Z. 
universities is on a semester system, and another has a mixture. 

As the reference point for U.S. educational programs, the under- 
graduate curriculum at a typical U.S. state university will be used. It 
is the program with which the writer is most familiar, but of greater 
importance is the fact that the College of Business and Economics (of 
which the Accounting Department is a part) is accredited by the 
American Assembly of Collegiate Schools of Business (AACSB). The 
AACSB reviews several factors in determining accreditation. These 



Preparation for the Accounting Profession 105 



include, among others, faculty qualifications, student qualifications, 
student/faculty ratio, library resources, and attitudes of the university 
administration. 

Another very important factor is the curriculum It is the view of 
the AACSB (and of virtually all business schools) that there should be 
a balance between the professional and nonprofessional subject areas. 
At least 40 percent of the four-year program must be completely 
outside of the business area. Subjects here would include the human- 
ities, sciences, social science, mathematics, and other electives in the 
"liberal arts." The professional subject matter includes accounting as 
well as nonaccounting areas. The nonaccounting business areas must 
include the business core consisting of behavioral sciences, market- 
ing, finance, production, and business policy. The accounting courses 
make up the balance of the curriculum. As can be observed from the 
appendix, it is normal for a significant portion of the nonbusiness 
courses to be taken in the first two years with the professional courses 
studied in the later years. While there will be variations among the 
U.S. universities as to the actual courses offered, the basic format 
indicated will normally be followed. 

A composite sample of several schools will be used for the United 
Kingdom (see appendix). As can be seen, education is somewhat 
narrower in the United Kingdom due to the shorter time period 
involved. A high proportion of the work is in accounting and finance. 
In all fairness, it should be pointed out that some of the areas specified 
by the AACSB, particularly finance, are often included as parts of 
other courses in the United Kingdom. The point is still valid that 
normally the U.K. student is not exposed to much of the "business 
core" or liberal arts. 

Are these differences between the U.K. and U.S. accounting educa- 
tion important? A recent editorial in Accountancy Age 3 argued that 
too many accountants in the United Kingdom were being educated 
only to keep score. The editor was quite forceful in indicating that as 
part of the management team, the accountant must be familiar with 
all aspects of business. This view is borne out by the opinions of many 
U.K. practitioners surveyed. They were concerned that accounting 
education in the United Kingdom is too narrow. The complaint is 
that graduates have little understanding of the operation of business 
outside of the accounting function. To be an adviser to management, 
an accountant should be able to understand the many aspects of a 
business organizaton. This attitude has caused some difficulty for 



'Opinion" (23 September 1977). 



106 INTERNATIONAL JOURNAL OF ACCOUNTING 



accounting students in the job market. (This will be discussed 
shortly.) This type of complaint is not common among U.S. and N.Z. 
practitioners. 

The setting of specific degree requirements is less clear in the six 
N.Z. universities. One of the universities does not require anything 
outside the accounting area. The other schools all specifically require 
mathematics and economics. In addition to the accounting and law 
courses, two of the schools require one year of courses normally 
thought of as being part of business administration. Only one — and 
this was the university where four years of study are required for the 
degree — has specific requirements approximating the "business core" 
as required by the AACSB in the United States. None of the N.Z. 
universities makes any meaningful effort to ensure that liberal arts 
and humanities be a part of an individual's collegiate education. 
While all students have electives and are encouraged to use these for 
subjects outside of the accounting area, it was generally conceded by 
the majority of academicians included in the study that very few 
students availed themselves of the opportunity but instead used their 
electives to take other courses directly related to their major. 

The fact that the U.S. academic year is divided into quarters or 
semesters results in continuous assessment. This concept has recently 
been introduced into N.Z. universities while in the United Kingdom, 
continuous assessment is the exception rather than the rule. In other 
words, in the United Kingdom, the grade for a course on which a 
student has worked for an entire year is determined only by an 
examination at the end. 

THE PROFESSION AND ITS VIEWS 

As in the United States, the N.Z. accounting profession is generally 
satisfied with the university accounting graduate, although some 
N.Z. practitioners did comment that many new graduates did not 
know enough of the basics of bookkeeping. 

Things are much different in the United Kingdom where the vast 
majority of practitioners interviewed expressed deep dissatisfaction 
with the university accounting education. As was pointed out earlier, 
accounting education as part of a university offering has been avail- 
able to substantial numbers of students in the United Kingdom for 
only ten to fifteen years. As a result, the vast majority of practitioners 
who participated in the study had no university degrees at all or had 
degrees in a variety of disciplines unrelated to accountancy. These 
people acquired their accounting (really bookkeeping) knowledge by 
correspondence, private "tutors" (cram courses for the professional 



Preparation for the Accounting Profession 107 



exam), and on-the-job apprenticeships. As several commented, "How 
did we ever learn anything about accounting theory?" 

In spite of the lack of a formal accounting education — or perhaps 
because of it — it was the general consensus that in today's environ- 
ment, a university education was essential for the entering profes- 
sional. (It should be noted that, until recently, it was normal practice 
for those deciding on an accounting career to start after "A" levels — 
secondary school — and become an apprenticed clerk.) In the past, 
individuals of higher academic potential simply did not go to the 
university if they wanted a career in accounting. The partners and 
accounting executives interviewed generally made a very clear dis- 
tinction between universities on one hand and the polytechnics and 
other institutions of higher education on the other. They made the 
assumption that now the more able students are those who attend the 
universities; those in the other institutions are those not good enough 
for the universities. It was readily conceded that this generalization is 
not absolutely true, but true enough so that practitioners do not take 
the time to visit those other institutions for recruiting purposes. 
Those views were mainly from officials of large firms and may not be 
representative of views of individuals from smaller firms. 

Although the practitioners were quite definite in stating that they 
were looking for university graduates, they were equally as definite in 
stating that the type of degree is unimportant; it is the person himself 
who matters. Many even indicated that they preferred "nonrelevant" 
(nonaccounting) graduates, particularly from Oxford or Cambridge. 
Frankly, this was shocking. In the United States, the norm is to recruit 
the accountancy graduate (with a bachelor's or master's degree) with 
the nonrelevant person being the exception. 

Why does this feeling exist in the United Kingdom? A number of 
reasons were given: 

1. Graduates from other disciplines were simply better. No one had 
any proof of this. It is probably a carry-over from the supposed 
superiority of degrees in the arts and classics from prestigious 
institutions. 

2. It seemed to be almost the universal consensus of the professionals 
that university accounting education is too conceptual. Many grad- 
uates are not prepared to "do" anything. It is the custom in the United 
Kingdom for those under training contracts (apprenticeship) to study 
basics of accounting from private tutoring firms. The larger em- 
ployers pay for these courses in addition to allowing the employees 
time off with pay to attend these sessions. 



108 INTERNATIONAL JOURNAL OF ACCOUNTING 



3. Those in the position to make hiring decisions do not have 
accountancy degrees. 

Only time, patience and aggressive action by accounting faculties 
will change these attitudes. 

The professionals in each country echoed a common complaint 
about their new recruits' lack of communication skills. At the author's 
school, an attempt is made to remedy this situation by requiring all 
accounting majors to elect at least one course in communications in 
addition to the required course in English composition. This is 
followed by assignments in accounting courses requiring students to 
demonstrate their communication skills. It is hoped that there will be 
a cumulative effect. 

There must be a much closer liaison between accounting faculties 
and members of the profession in the United Kingdom. There 
appears to be a lack of effort on both sides to establish a meaningful 
relationship. A selling job must be done on the profession (assuming, 
of course, that there is a product to sell — and it is believed there is). 

As was indicated earlier, one of the complaints of practitioners in 
the United Kingdom has been that university accounting education is 
too conceptual and that graduates are not equipped to work effec- 
tively except after additional training. While almost everyone had 
such complaints, as far as could be determined, nothing has been 
done in an organized fashion by any of the professional groups to 
communicate these feelings to the universities. The members of the 
profession must be more aggressive if they are to have an impact on 
education. 

The practitioners interviewed in New Zealand all stated that there 
are excellent relationships with the universities. When this subject 
was pursued further, it was found that what this really meant was that 
they knew the head of the acounting group at each school because of 
his involvement in the professional society activities. It was conceded 
on both sides that not enough effort has been expended to develop 
meaningful relationships. At least at some of the universities, the 
greater fault lies with the faculty. Even those faculty who are society 
members rarely attend meetings or involve themselves in society 
business. 

The writer's experience in the United States indicates that it is 
established policy on both sides to encourage interaction and the 
development of friendly relations. The establishment of faculty 
fellowships in public or industrial accounting is one illustration of 
the implementation of this policy. Faculty members in the United 



Preparation for the Accounting Profession 109 



States are encouraged to join and participate actively in the various 
professional groups. 

OTHER MATTERS 

Professional Examinations 

The author has not conducted sufficient research to determine if in 
fact New Zealand is the only country where professional examina- 
tions are not required for university graduates who have passed 
designated courses and who wish to become CAs. In other countries, a 
comprehensive examination prepared by the appropriate professional 
group must be successfully passed before an individual can become a 
CA or CPA. Such an examination is not required in New Zealand for 
university graduates who have taken the proper courses. With the 
appropriate education and three years of experience with a firm of 
chartered accountants, the awarding of a CA certificate is virtually 
automatic. 

Under this system, the New Zealand Society of Accountants ap- 
points an assessor or liaison for each of the universities. This indi- 
vidual reviews course content and examinations as well as the grad- 
ing procedure, and reports the findings to the society. This is an 
attempt to ensure that the universities are teaching what the society 
thinks should be taught and are testing for learning adequately. The 
practitioners, in particular, seemed to like this approach, indicating 
that with only six universities, adequate assessment of the universities' 
programs is possible. 

It was interesting to find, however, that while most practitioners 
interviewed claimed to be satisfied, many admitted that they did not 
like hiring graduates from two of the universities because of in- 
adequate preparation. The same two schools were named consis- 
tently. This would seem to indicate that placing the burden on the 
universities to ensure preparation for the profession was not really 
working as well as hoped. 

Accounting department heads were neutral on the subject of pro- 
fessional comprehensive exams. Several did comment that if such 
exams were instituted, it would give them greater flexibility in the 
type of accounting courses taught. 

Women in the Profession 

With the experience of Equal Opportunity and Affirmative Action as 
a background, it was surprising and even disturbing to discover that 
many N.Z. professionals in the position to make policy decisions are 



110 INTERNATIONAL JOURNAL OF ACCOUNTING 



very set against women in auditing positions. (It is through auditing 
that people usually advance to partnership status. ) The usual reasons 
given were thai women will move with husbands, become pregnant 
and raise a family, are not as reliable as men, and cannot make 
decisions. This attitude is certainly not true for all offices or for all 
firms. However, those who openly seek women because they are as 
good as men appear still to be in the minoi it\ . 

There appears to be less obvious discrimination in the United 
Kingdom, but it does exist. There appears to be an undercurrent of 
bias against hiring women for reasons similar to those listed by N.Z. 
practitioners. A potentially valuable resource is not being used to its 
fullest in the United Kingdom and New Zealand at the present time. 
There is no doubt that in the past five years, women have had fully 
equal opportunities with men in the accounting profession in the 
United States. 

Salaries 

In New Zealand as in the United Kingdom, starting salaries in 
industry and government are significantly higher than in public 
accounting (about 15 to 20 percent higher). The comment was 
frequently made that compensation in public accounting often sur- 
passed that in industry and government after two or three years. In 
New Zealand, guidelines for starting salaries are generally agreed 
upon by the major firms in the different localities. While salaries in 
the United States and United Kingdom are competitive, there are 
differences among the various firms. There are also differences among 
the N.Z. firms. However, the impression obtained was that starting 
salaries were closer together in New Zealand due to the guidelines 
agreed upon by committees of public practice of the local branch of 
the New Zealand Society of Accountants in each major employment 
area. In general in the United States, the public accounting profes- 
sion is fully competitive with industry, and is often ahead of govern- 
ment units in terms of salary. 

RECOGNITION AS A PROFESSIONAL— USE OF THE ALPHABET 

There are six different professional accounting organizations in the 
United Kingdom, each with its own series of examinations which 
candidates must pass as one of the requirements for membership. 
These are the following: 

1. Institute of Chartered Accountants in England and Wales 
(ICAEW); 



Preparation for the Accounting Profession 1 1 1 



2. Association of Certified Accountants (ACA); 

3. Institute of Chartered Accountants of Scotland (ICAS); 

4. Institute of Cost and Management Accountants (ICMA); 

5. The Chartered Institute of Public Finance and Accountancy 
(CIPFA); and 

6. Institute of Chartered Accountants in Ireland (ICAI). 

Each of these is at least national in scope with the opportunities for 
membership often available on an international basis within the 
British Commonwealth. 

Only one of the six accounting organizations requires higher edu- 
cation as a prerequisite to membership — ICAS. As late as 1975, barely 
more than half of the new entrants to the ICAEW were university 
graduates. 4 In general, these bodies allow a waiver of portions of the 
examinations for appropriate courses from specified institutions of 
higher learning. However, a final comprehensive examination is 
required of all candidates for each of the institutes. In all cases, the 
organizations sponsor courses to prepare individuals to sit for the 
various levels of examinations. Here, again, the Scottish Institute is 
unique. It employs full-time staff to instruct its courses. The other 
organizations depend on public or private institutions to do the 
required teaching. The accountancy bodies all require practical 
experience in addition to an examination. A training contract is 
signed by both employer and employee. The term of the contract can 
vary from three to five years, depending on the level and type of 
formal education completed. While an employee can change posi- 
tions, approval of the change must be obtained from the appropriate 
institute, and the new employer must be willing to sign a training 
contract for the remaining period of required experience. It appears 
that the employer who has signed a training contract is somewhat 
constrained if an individual proves to be unsatisfactory. 

In the United States, membership possibilities are somewhat more 
confused. There are several national organizations: 

1. American Institute of Certified Public Accountants (AICPA); 

2. National Association of Accountants (NAA); and 

3. Institute of Internal Auditors (IIA). 

While the three U.S. organizations are all national in scope, 
membership in the AICPA is possible only if an individual has been 

4 Bryan Carsberg, "The Education of the Accountant," in Education for the Profession, 
by J. D. Turner and J. Rushton (Manchester, England: Manchester University Press, 
1976), p. 15. 



112 INTERNATIONAL JOURNAL OF ACCOUNTING 



awarded a CPA certificate by one of the fifty-four jurisdictions 
authorized to issue such certificates (the fifty states plus several other 
localities). In other words, there are fifty-four different sets of regula- 
tions governing education and experience. In all cases, a written 
examination is required. It is uniformly prepared and graded by the 
AICPA with the results forwarded to each jurisdiction. Most states 
require a university degree in accountancy as well as experience (one 
to two years) in addition to the examination. Membership in the NAA 
and the IIA is open to anyone who has the interest. Only recently have 
these two organizations developed examinations to test knowledge in 
the fields of managerial accounting and internal auditing, respec- 
tively. Upon successfully passing the examination, a person will 
receive a certificate in management accounting (CMA) or certificate 
in internal auditing (CIA) which indicates the level of knowledge 
demonstrated. At the present time, membership in the organizations 
is not related to the successful passing of the examination. 

In New Zealand, there is a single professional organization — The 
New Zealand Society of Accountants. This organization is a combina- 
tion of two previous associations, one of public accountants and the 
other cost accountants. As indicated earlier, a university graduate 
with the proper courses can become a CA after three years with a firm 
of chartered accountants. For someone interested in industry, other 
courses are required to join the cost group. Those who do not have a 
university degree must sit for a series of examinations and gain 
practical experience in order to become members. 

SUMMARY AND A LOOK AT THE FUTURE— UNITED KINGDOM 

It was not unexpected that there would be a difference in education 
for the accounting profession between the United States and the 
United Kingdom. While the profession really started in the United 
Kingdom (many of the large U.S. firms owe their start to immigrants 
from Scotland and England), preparation for it via the formal educa- 
tion route was a factor in U.S. life long before it started in the United 
Kingdom. The very fact that the U.S. society as a whole has expanded 
and changed rapidly may be a factor in the rapid growth of the 
accounting profession. Continuing changes in the United States are 
evidenced by the recent interest in accreditation of academic pro- 
grams in accounting. 5 The major movement in the United States 

^American Insti tute of Certified Public Accountants, /who/ Report, Board on . Standards 
for Programs and Schools of Professional Accounting (New York: AICPA, 1977): 
American Accounting Association, Committee on Accounting Education, Standards 
for Professional Accounting Education (Menasha. Wis.: AAA, 1977). 



Preparation for the Accounting Profession 1 13 



appears to be towards requiring a minimum of five years of education 
to prepare the professional accountant. It is the opinion of many 
educators and practitioners that four years is simply not enough time 
to prepare the educated professional. Pressure for increased education 
beyond the present three-year program did not seem to exist in the 
United Kingdom, although there is a very strong movement toward 
requiring university graduation. In the writer's opinion, it is in- 
cumbent on both the universities and the profession in the United 
Kingdom to work together to develop a viable accounting education 
from which the graduate will be eagerly accepted. In addition, it is 
essential that the programs of the future be designed for a longer 
period of time than is presently true. After all, the study of law is now 
longer than that required for accounting. Is the accounting profes- 
sion any less of a profession than law? Based on general observations, 
it appears that university accounting education is slowly moving 
toward a better balance between theory and practice. 

SUMMARY AND A LOOK AT THE FUTURE— NEW ZEALAND 

On the whole, education for the accounting profession in New 
Zealand is not too different from such education in the United States. 
It is believed, however, that improvements are needed in two areas, 
the first related to the length of time for education. A larger body of 
knowledge could be taught given additional time, and accounting 
students would be much more broadly educated as well. It is strongly 
recommended that education authorities in New Zealand recognize 
the advantage of at least a four-year education. If that is accomplished, 
guidelines similar to those recommended by the AACSB would be 
followed. As has been stated, accounting education in the United 
States is rapidly moving toward a five-year requirement. 

The second major change recommended would be for the New 
Zealand Society of Accountants to institute an examination for all 
those who wish to enter public practice. Such a step would assure 
some minimum uniformity of preparation for candidates seeking to 
enter the profession. 

It must be noted that the recommendations made are those of the 
writer based on his experience and observations. In general, the 
members of the practicing profession were satisfied with present 
conditions and did not perceive a need for additional education or a 
comprehensive examination. 



114 INTERNATIONAL JOURNAL OF ACCOUNTING 



APPENDIX 

A U.S. State University 



I 'nited Kingdom 



B. S. in Accounting 



B. A. in Economics and Social 
Studies, B. A. in Accounting and 
Finance 



First Year — separated by semesters Composite U.K. Curricula 



Economics 
Math calculus 
English composition 
General electives 



— 1 year 

— 1 year 
— 1 semester 

— 5 semesters 



Second Year — separated by semesters 



Accounting 

Statistics 

Math and or science 

Computer science 

Economics 

General electives 



— 1 year 

— 1 year 

— 1 year 

— 1 semester 

— 1 semester 
—3 semesters 



Third Year — separated by semesters 



Intermediate 

accounting (theory 
Managerial cost 

accounting 
Marketing 
Finance 

General electives 
Production 

management 
Communications 

elective 
Business elective 
Economics elective 



— 1 year 

•1 semester 
■1 semester 
■1 semester 
■1 semester 

•1 semester 

•1 semester 
•1 semester 

— 1 vear 



Fourth Year — separated by semesters 



Business law- 
Auditing 

Advanced accounting 
Taxes 

Security analysis 
Business elective 
General elective 
Business policy 



— 1 year 

— 1 semester 

— 1 semester 

— 1 semester 

— 1 semester 

— 1 semester 

— 1 year 

— 1 semester 



Year 1 — In general, courses run for a 
full academic year. 

Accounting 

Economics 

Two or three other courses, some 

specified in quantitative methods, 

sociology', or economics. 



Year 2 



Accounting — 2 courses 

Economics 

Finance 

Math or statistics 



Year 3 



Accounting — 2 courses 
Electives from 

Economics 

Law 

Social sciences 



The Equity Method of Accounting for Investments in 
Common Stock: The New Zealand Experience 

G. GNIEWOSZ* 

Accounting for investments in stock of other corporations has been a 
controversial area of external financial reporting for many years. 
Only in relatively recent years has it become generally accepted that 
investments are to be divided into three categories — subsidiaries, 
investments which can be significantly influenced, and portfolio 
investments — and that the methods of accounting for these three 
categories should be different, after considering the nature of the 
investment. 

Accounting for those investments which can be influenced by the 
investor corporation has been standardized through the pronounce- 
ment of standards by most of the major accounting bodies of the 
English-speaking world. In New Zealand, the Council of the New 
Zealand Society of Accountants have accepted the Statement of Stan- 
dard Accounting Practice No. 2 — Accounting for Associated Com- 
panies (Equity Accounting), 1 the equivalent to APB No. 18 2 in the 
United States. 

The objectives of this article are first to state the position in New 
Zealand regarding the equity method of accounting for investments 
in common stock and to highlight some of the main differences with 
APB No. 18 and the pronouncements and exposure drafts in certain 
other English-speaking countries. Second, it will report the financial 
reporting practice of N.Z. -listed public corporations in the light of 
the recommendations of SSAP No. 2. 



*G. Gniewosz is lecturer in accounting at Churchlands College of Advanced Educa- 
tion, Australia. 

'Hereafter referred to as SSAP No. 2. 

Reference will be made to APB 18, although it is recognized that it has been 
incorporated into the AICPA Professional Standards as AC Section 5131. 



116 INTERNATIONAL JOURNAL OF ACCOUNTING 



The information for this study was obtained from the following 
main sources: 

1. A review of the equity accounting pronouncements and exposure 
drafts of accountancy bodies in several English-speaking countries 3 
and a review of the literature discussing accounting for investments 
in common stock of other corporations included in these pronounce- 
ments and exposure drafts; 

2. An examination of the first annual financial reports of 235 listed 
New Zealand public-issued corporations after SSAP No. 2 became 
operative. This group represents approximately 95 percent of all 
listed public corporations in New Zealand; 4 and 

3. The results of interviews with executives who represent forty-one 
corporations from Auckland, Wellington, and Christchurch which 
had adopted SSAP No. 2. The purpose of the interviews was to obtain 
an insight into three main areas: (a) interpretation by corporations of 
certain terms used in SSAP No. 2; (b) accounting problems encoun- 
tered with the adoption of SSAP No. 2; and (c) views held by corpora- 
tion executives as to the usefulness of financial reports prepared on an 
accounting basis. 

EXTERNAL FINANCIAL REPORTING IN NEW ZEALAND 

To appreciate SSAP No. 2 more fully, it may be useful to consider 
financial reporting requirements in New Zealand in general and the 
role played by Statements of Standard Accounting Practice in 
particular. 

External financial reporting in New Zealand is largely influenced 
by the requirement in the New Zealand Companies Act of 1955 that 

Every balance sheet of a company shall give a true and fair view of the state of 
affairs of the company as at the end of its financial year, and every profit and 
loss account of a company shall give a true and fair view of the profit or loss of 
the company for the financial year. 5 

5 The review rovered the pronouncements and exposure drafts of New Zealand, the 
United Kingdom, the United States, Canada, Australia, and the International Standard 
issued hv the International Standards Committee. 

4 To be listed on the New Zealand Stock Exchange a corporation must comply with the 
listing requirements of the Stock Exchange Association of New Zealand. Among other 
things, one of the requirements for listing is a certain spread of stock ownership, stated 
in sections 302 3 of the Listing Manual as: 
In any one class of equity share, the minimum spread shall be — 

(a) at least 200 shareholders each holding not less than a marketable parcel and 

(b) 25% of the number of issued shares of the class with a minimum of $100,000 
nominal value, held by members of the public. 

Where the issued equity shares of any one class are of a nominal value of less than 
$400,000. the minimum number of shareholders (each holding not less than a 
marketable parcel) may be 100, provided paragraph 302 is otherwise complied with. 
5 New Zealand Companies Act 1955, Section 153 (1). 



Accounting for Investments 1 1 7 



It is within this overriding "true and fair view" requirement that the 
council of the New Zealand Society of Accountants issued its State- 
ments of Standard Accounting Practice, thus providing a more 
definitive interpretation of the "true and fair view" requirement. 
Standards are issued to describe methods of accounting approved by 
the council of the Society for application to all external financial 
statements. "External" in this context is interpreted as statements for 
other than internal management use. 

While they are not legally binding, the standards are to be observed 
by members of the Society whenever appropriate. It is recognized, 
however, that no standard, no matter how comprehensive, can pro- 
vide for all possibilities or circumstances; for this reason, the state- 
ments themselves provide for the possibility of departure. Significant 
departures are to be disclosed and explained, and the financial effects 
estimated and disclosed unless this is impractical or misleading. 

As far as the auditors' position is concerned, all significant de- 
partures should be noted in the auditors' report and any significant 
departure quantified. The auditor is not required to make a positive 
statement to the effect that all standards as pronounced by the Society 
have been complied with in the same way that he or she is required to 
make a positive statement in respect to the compliance with the 
provisions of the Companies Act. The auditor shall merely refer to 
any departure which materially affects the financial statements as 
stated. 

The current series of standards began in 1974 and by August 1978, 
the following seven standards had been pronounced: 



S_SAP 
1 



Disclosure of Accounting 

Policies 

Accounting for Associated 

Companies (equity accounting) 

Depreciation of Fixed Assets 



Valuation and Presentation of 
Inventories in the Context of the 
Historical Cost System 
(incorporating IAS-2) 
Events Occuring after 
Balance Date 
Materiality in Financial 
Statements 

Extra-ordinary Items and Prior 
Period Adjustments 



Date pronounced 
November 1974 

December 1974 

August 1975 
(Amended April 
1977) 
November 1975 



Effectwe date 
January 1, 1975 

April 1, 1975 

April 1, 1975 

March 31, 1976 



December 1976 March 31, 1977 



August 1977 December 31, 1977 



December 1977 



March 31. 1978 



118 INTERNATIONAL JOURNAL OF ACCOUNTING 



In addition to these standards, the following exposure drafts were still 
outstanding by August 1978: 

Exposure 

Draft Issue date 

14 Accounting in Terms of Current Costs August 1976 

and Values 

16 Consolidated Financial Statements February 1977 

17 Information to be Disclosed in Company February 1977 
Balance Sheets and Profit and Loss 

Accounts 

18 Statement of Sources and Application of April 1977 
Funds 

19 Expenditure Carried Forward to September 1977 
Subsequent Accounting Periods 

20 Accounting for Income Taxes June 1978 

The sudden surge in exposure drafts and pronouncement of stand- 
ards in New Zealand has not been without criticism. Some in the 
financial press have publicly labelled the drafts "costly non-pro- 
ductive work," representing a handicap to corporation profitability. 

INVESTEES FOR WHICH EQUITY ACCOUNTING IS APPROPRIATE 6 

In New Zealand, the equity method of accounting is used only for 
investments in what can be defined as "associated companies" as per 
SSAP No. 2, paragraph 3.1: 

A company (not being a subsidiary of the investing company) is an associated 
company of the investing company if: 

a) The investing company's interest in the associated company is effectively 
that of a partner in a joint venture or consortium: 

b) The investing company's interest in the associated company is for the long 
term, substantial, and material either as to the amount invested or as to 



The overall results of the survey of the first annual report of 235 public corporations 
listed in New Zealand after SSAP No. 2 became operative are as follows: 



No stock in other corporations 

Made no reference to assoc-iated companies (or SSAP 

No. 2) but had stocks in other corporations (SSAP 

No. 2 not adopted) 
Stated that SSAP No. 2 was not adopted 
Adopted SSAP No. 2 



No. of 




companies 


a- 


47 


20 


75 

40 

73 

235 


32 

17 

31 

100 



Accounting for Investments 119 



profits and losses, and having regard to the disposition of the other share- 
holdings, the investing company is in a position to exercise significant 
influence over the associated company. 
In both cases it is essential that the investing company participates (usually 
through representation on the board) in commercial and financial policy 
decisions of the associated company, including the distribution of profits. 

The use of the equity method, as outlined in SSAP No. 2, is 
currently not extended to accounting for unconsolidated subsidiaries. 
A subsidiary company is explicitly excluded from the definition of an 
associated company, while SSAP No. 2 is restricted to companies 
which can be defined as associated companies in accordance with 
SSAP No. 2. There is currently no other standard which would make 
the equity method acceptable for unconsolidated subsidiaries. 7 In 
contrast, the American Institute of Certified Public Accountants 
(AICPA) has gone a step further in APB 18 by permitting the exten- 
sion of the application of the equity method to accounting for 
unconsolidated subsidiaries, both domestic and foreign, in the con- 
solidated financial statements. 8 

The definition of an associated company in SSAP No. 2 is made in 
terms of investments in "companies." Unfortunately, it is not clear 
whether the term "companies" means only legally incorporated 
corporations or whether it is used in a more general way to include 
partnerships and unincorporated joint ventures as well. However, the 
tenor of the whole statement seems to exclude unincorporated 
businesses from the definition of an associated company. 

This limitation of the definition of associated companies seems to 
be consistent with the opinion of the Accounting Principles Board, as 
expressed in APB 18. However, the Accounting Principles Board also 
notes that "many of the provisions of the Opinion would be appro- 
priate in accounting for investments in these unincorporated enti- 
ties." 9 In contrast, the Canadian Institute of Chartered Accountants 
(CICA) does not limit the application of the equity method to legally 
incorporated investees but states that, for the purpose of handbook 
section 3055, "a joint venture may be incorporated or unincorpo- 
rated." 10 Unlike the CICA which deals with joint ventures and other 



7 Ho\vever, it is proposed in Exposure Draft No. 16 that the equitv method be extended 

to unconsolidated subsidiaries. 

8 American Institute of Certified Public Accountants, APB 18, Paragraph 11 (New 

York: AICPA. 1971). 

'American Institute of Certified Public Accountants, Accounting Interpretations of 

APB Opinion No. 18, Interpretation No. 2 (New York: AICPA. 1971). 

'"Canadian Institute of Chartered Accountants, Handbook, Section 3055.05 (Toronto: 

CICA. 1977). 



120 INTERNATIONAL JOl'RNAL OF ACCOUNTING 



certain long-term investments in two separate handbook sections, in 
New Zealand both types of investees are covered in one standard, that 
is, SSAP Xo. 2. 

For the purpose of SSAP No. 2, a joint venture or consortium is 
defined as 

a company owned or operated by a small group of investors as a separate and 
specific business or project for the mutual benefit of the group (which may 
include the government) each of whom participates directly or indirectly in 
the overall management of the companv. 

(Note: While the ownership of the major shareholdings in a joint venture or 
consortium would seldom change and normally its shares woidd not be 
traded publicly, a minority public ownership would not preclude a company 
from being a joint venture or consortium.) 11 

Unlike the recommendations of the CICA, proportionate consolida- 
tion is not mentioned as an alternative reporting method for joint 
ventures in certain circumstances in SSAP No. 2. 

An investee corporation, other than a joint venture or consortium, 
is defined as an associated companv if the investor corporation's 
interest in the investee is: ( 1 ) long term; and (2) substantial; 12 and (3) 
material, either as to the amount invested or as to profits/losses; and 
(4) the investor corporation is in a position to exercise significant 
influence, having regard to the disposition of the other stockholders. 

Similar to the other pronouncements and exposure drafts exam- 
ined, the main justification for the equity method seems to be the 
criterion of "significant influence." Opponents of the equity meth- 
ods have argued that the term significant influence is too vague to 
expect uniform application and that the guideline of 20 percent is 
purely arbitrary. 13 Interviews with executives of forty-one corpora- 
tions revealed that the major criteria used in defining an associated 
company were percentage ownership and representation on the board 
of directors. The other criteria were largely ignored. In other words, 
the majority of executives stated that the decision to adopt the equity 
method was based mainly on the arbitrary rule of ownership and 
board representation. Furthermore, the various terms used in SSAP 
No. 2 to define an associated company were interpreted in various 
ways by individual companies, and there was limited evidence of a 
clear consensus of opinion. 



"SSAP No. 2. Paragraph 3.1. 

12 T\venty percent of equity voting rights is stated as a prima facie guideline for the 

interpretation of the term "substantial." 

ls For example. E. S. Hendriksen, Accounting Theory, 3rd ed. (Homewood. III.: 

Richard D. Irwin. Incorporated. 1977). 



Accounting for Investments 121 



ACCOUNTING PRACTICE VERSUS CONSOLIDATION PRACTICE ONLY 

The equity method can be considered from two different points of 
view. On the one hand, it can be regarded as an alternative to the cost 
method, or the market value method, in accounting for certain invest- 
ments in the books of the investor itself. Alternatively, the equity 
method can be regarded as an alternative way of incorporating certain 
investments, such as associated companies, in the consolidated finan- 
cial statements only. 

SSAP No. 2 restricts the principles of equity accounting to consoli- 
dated financial statements; that is, the equity method is considered 
only appropriate in the context of preparing financial reports for a 
group of corporations considered as one economic entity. In the 
books of the investor as a legal entity, associated companies are not to 
be shown on an equity accounting basis. Unfortunately, no indica- 
tion is given in SSAP No. 2 or in any other standard in New Zealand as 
to the value at which associated companies should be carried in the 
accounts of the investor itself. 

Contrary to the recommendations in SSAP No. 2, there is the view 
that equity accounting is 

. . . simply ... a method of accounting, on an accrual basis, for income from 
certain classes of investments, thereby ensuring improved reporting on the 
worth of the particular investments to the investor. This view being taken, it 
is desirable that the equity method be employed in the first instance in the 
accounting records and financial statements of the investor itself as the 
primary accounting unit and, merely as a consequence thereof, also in the 
consolidated financial statements. Moreover, having regard to the essentially 
similar characteristics of investments in associated companies, it is logical 
that application of the equity method in the accounting records and financial 
statements of the investor itself should extend to subsidiaries as well as to 
associated companies. 14 

A similar view is expressed in APB 18, paragraph 17: "When the 
equity method is appropriate, it should be applied in consolidated 
financial statements and in parent-company financial statements 
prepared for issuance to stockholders as the financial statements of 
the primary reporting entity" (emphasis added). From both of these 
statements it is clear that the equity method is considered appropriate 
not merely in the preparation of consolidated financial statements 
but also for the accounting in the books of the investor itself. 



'■•Australian Society of Accountants and the Institute of Chartered Accountants in 
Australia, Second Australian Exposure Draft, paragraph 19 (Melbourne: ASA and 
ICAA, September 1973). 



122 INTERNATIONAL JOURNAL OF ACCOUNTING 



One of the major arguments advanced against the application of 
the equity method is that the retained earnings of the associated 
companies have not been realized as far as the investor is concerned. 15 
The requirement in SSAP No. 2 to include an associated company's 
retained earnings as part of the consolidated income of the economic 
entity, although disclosed as a separate item, is similar to the inclu- 
sion of the retained earnings of a subsidiary. The distinction is merely 
that the investor "controls" the distribution of the subsidiary's re- 
tained earnings whereas the distribution of the associated company's 
retained earnings is only "significantly influenced." In both cases, 
retained earnings are only recognized in the calculation of income of 
the economic entity. 

The implication of this distinction is that, due to the inclusion of 
the investor's share of an associated company's retained earnings in 
consolidated income of the economic entity, the economic entity is 
indirectly redefined. The new economic entity is based on "control" 
and "significant influence" whereas previously it was based merely 
on "control." In the context of SSAP No. 2, the requirement for 
adherence to the "realization" concept is therefore met. 

If, on the other hand, it is recommended, as in the case of the Second 
Australian Exposure Draft (1973) and APB 18, that the equity method 
be used for the purpose of actual book entries by the investor as a legal 
entity, the problem of the "realization" concept must be resolved. The 
question is whether the "realization" concept is interpreted in terms 
of actual dividends received receivable or in terms of absolute "con- 
trol" over dividend policy, or whether an interpretation in terms of 
"significant influence" over dividend policy is preferable in the light 
of the "true and fair view" requirement for external financial report- 
ing, the expression used in New Zealand. 

PROPOSED METHOD FOR RECOGNIZING INCOME FROM ASSOCIATED 
COMPANIES 

Under the equity method, the investor recognizes income from an 
associated company at the time it is reported as income by the 
associated company itself, rather than at the time dividends are 
received/receivable from the associated company. Although this 
basic recommendation is universal in the various pronouncements 
and exposure drafts examined, there are differences in the accounting 



15 American Institute of Certified Public Accountants, Comment Letter No. 11 on 
Exposure Draft on Proposed Opinion No. 18: The Equity Method of Accounting for 
Investments in Common Stock (New York: AICPA, 1971). 



Accounting for Investments 123 



adjustments recommended, in particular in regard to the elimination 
of unrealized profits on intercompany transfers. 

The following statement in SSAP No. 2 summarizes the required 
accounting adjustments for the purpose of recording income from 
associated companies: 

Wherever the effect is material, adjustments similar to those adopted for the 
purpose of presenting consolidated accounts should be made to exclude from 
the investing company's consolidated accounts such items as unrealised 
profits on stocks transferred to or from associated companies. . . , 16 

Unfortunately, there is presentlv no guideline available in New 
Zealand in the form of a Statement of Standard Accounting Practice 
for the preparation of consolidated financial statements, and in par- 
ticular for the proportion of the elimination of unrealized profit. 17 
An examination of other pronouncements and exposure drafts 
reveals a disagreement in the recommended proportion of unrealized 
profits to be eliminated. The CICA makes the following recommen- 
dation in respect to unrealized profits losses on intercompany trans- 
actions of the consolidated group: 

Complete elimination of unrealized intercompany gains or losses and ad- 
justments of applicable income taxes is necessary so that assets may be 
presented at historic cost to the consolidated entity. There is a view that, 
where a minority interest exists, a proportion of any intercompany transac- 
tion may be considered to have been at arm's length, and that the proportion 
of the gains or losses relating to the minority interest would be recognized in 
computing income. This view is inconsistent with the fact that the parent and 
its subsidiary are related and therefore not operating at arm's length. For this 
reason, unrealized intercompany gains or losses should be entirely elimi- 
nated. (For treatment of gains or losses on transactions between a venturer 
and a joint venture, see . . .) 18 

Although this recommendation relates purely to subsidiaries, the 
same recommendation is made indirectly in the case of associated 
companies (excluding joint ventures) when it is stated in Handbook 
Section 1600.73 that, "Accounting for an investment under the equity 
method results in the net income of the investor being the same as the 
consolidated net income would have been if the financial statements 
of the investee had been consolidated with those of the investor." 



16 SSAP No. 2. Paragraph 4.5. 

"It is, however, stated in Exposure Draft No. 16, paragraph 5.4. (r) that The portion of 

unrealised profits arising in the current period should be charged against consolidated 

income with appropriate adjustment to minority interesi " 

'"Canadian Institute of Chartered Accountants. Handbook Section 1600.28, (Toronto 

CICA, 1977). 



124 INTERNATIONAL JOURNAL OF ACCOUNTING 



On the other hand, unrealized profits on intercompany transfers 
between a joint venturer and joint venture are subject to the following 
recommendation: 

As the fellow venturers participate in the control of the joint venture, the 
venturer involved in the transaction could be considered to be dealing at 
arm's length with several independent parties. On this basis, a gain can be 
considered to have been realized to the extent of the interests of the other joint 
venturers and that proportion should be recognized. 19 

In the case of a loss arising from the transaction between the 
venturer and the joint venture, it is recommended that the entire loss 
be recognized. It is reasoned that "Failure to recognize the entire loss 
ignores the existence of evidence which supports the fact that there 
has been an impairment in the value of the asset transferred." 20 

The Accounting Principles Board of the AICPA maintains that the 
question of "whether all or a proportionate part of the intercompany 
profit or loss should be eliminated under the equity method depends 
largely upon the relationship between the investor and investee." 21 

It is argued that 

When an investor controls an investee through majority voting interest and 
enters into a transaction with an investee which is not on an "arm's length" 
basis, none of the intercompany profit or loss from the transaction should be 
recognized in income by the investor. . . . 

In other cases, it would be appropriate for the investor to eliminate inter- 
company profit in relation to the investor's common stock interest in the 
investee. 22 

In the second Australian exposure draft, the argument for the 
elimination of unrealized profits on intercompany transactions on 
the basis of percentage ownership is stated as follows: 

In applying the equity method, unrealised profits or losses of either the 
investor or the investees concerned, arising from transactions between the 
investor and those investees, or between those investees themselves, should be 
eliminated in the same manner as if the financial statements of the investees 
were being consolidated with those of the investor. In so far as such profits or 
losses have been recognized in the accounts of the investees, the elimination 
should be limited to the investor's proportionate share. 23 



19 Ibid., Handbook Section 3055.18. 

20 Ibid., Subsection 21. 

21 American Institute of Certified Public Accountants, Accounting Interpretations of 

Opinion No. 18: Intercompany Profit Eliminations under Equity Method (New York: 

AICPA. 1971). 

22 Ibid. 

23 Paragraph 30. 



Accounting for Investments 125 



In the light of such diverse professional opinion and the lack of 
guidance in SSAP No. 2, it is not surprising to find a variety of 
accounting practices followed by listed public corporations in New 
Zealand. Exhibit 1 represents a summary of the responses by corpora- 
tion executives concerning the accounting practices followed in 
eliminating unrealized profits on intercompany inventory transfers. 

The conclusion which can be drawn from exhibit 1 is that, al- 
though unrealized profits on intercompany transfers are not material 
in a large proportion of those corporation executives interviewed, 
there was considerable variation in practice where the amounts 
involved were considered material. 



Exhibit 1. Unrealized Profit Elimination Practice 

Percentage of all 
corporations 
interviewed 

No elimination — not material 30.0 
No elimination — inventory at year end is consistent 

from year to year 5.0 

No elimination — no reason given 2.5 

No elimination — only arm's length transactions 5.0 

No elimination — transfer on cost basis 2.5 

No elimination — not really considered 5.0 

No transactions with associated companies 17.5 
No inventory from intercompany transfer held at 

end of year 2.5 

Eliminated — on percentage ownership basis 7.5 

Eliminated — 100 percent 12.5 
No current elimination but will do so on percentage 

ownership basis 5.0 

No current elimination — but will do so 100 percent 2.5 
Eliminated — inventory 100 percent, fixed assets on 

percentage ownership basis 2.5 

100.0 



REASONS FOR NOT APPLYING EQUITY ACCOUNTING 

There are two main reasons outlined in SSAP No. 2, paragraph 4.4, 
for the nonadoption of equity accounting: 

An associated company's results should be omitted from the consolidated 
accounts only on the same grounds as those which would permit group 
accounts not to deal with a subsidiary, notably if the inclusion of such results: 



126 INTERNATIONAL JOURNAL OF ACCOUNTING 



(a) Would involve expense or delay out of proportion to the members of the 
investing company; or 

(b) Would be misleading 

The reason for omission should be stated. 24 

This means that the decision whether or not "an associated com- 
pany's results should be omitted from the consolidated accounts" 
should be made on the basis of a cost/benefit analysis, that is, the 
benefits 25 (in terms of valuable information) from the adoption of 
SSAP No. 2 should outweigh the costs (in terms of expenses, or 
delaying information) of applying it. 

The second reason for not applying equity accounting, that is, "if 
the results would be misleading," is probably the more important. 
Information is to be omitted if it would lead to wrong economic 
decisions. Unfortunately, no guidelines are provided for situations in 
which the inclusion of an associated company on an equity account- 
ing basis would be misleading. Paragraph 4.4 specifies that not only 
should the fact be stated that any associated company's results are 
omitted, but that also the reason for such an omission should be 
included. 

One further point must be stressed. The requirement that the 
reason for omitting the results of associated companies be stated refers 
only to investees (defined as associated companies according to SSAP 
No. 2). For example, a statement such as "We have no significant 
influence over the associated company" is a contradiction. This 
statement is merely saying that the investee company is not an 
associated company and therefore SSAP No. 2 is not applicable by 
definition. 

The result of the survey of the forty companies which stated that 
SSAP No. 2 had not been adopted is summarized in exhibit 2. 

By far the most common reason given was that the inclusion of the 
associated companies' results would not materially affect the overall 
results as published. Unfortunately, most companies did not indicate 
in their annual report what they perceived to be "material." In six 
cases, various reasons were advanced for not adopting SSAP No. 2, 
such as no worthwhile information would result; adoption could 



24 SSAP No. 2, Paragraph 4.4. This paragraph is similar to subsections 154(2)(b)(i)(ii)of 
the New Zealand Companies Art 1955 which exempt a holding company from 
preparing consolidated statements under similar circumstances. 
25 The concept of "measuring the benefits" derived from including the results of 
associated companies is operational if it is interpreted in the context of "materiality." 
Materiality is defined in general terms in SSAP No. 6: "Materiality in Financial 
Statements." issued bv the Council of the New Zealand Society of Accountants, August 
1977. 



Accounting for Investments 127 



Exhibit 2. Reasons for not Applying Equity Accounting 

Auditor 



Repeats 
No. of same No 

companies statement Disagrees comment 



Not material 


25 


1 


No significant influence 
over associated company 
Various reasons 


3 
6 


2 


No reason given 


6 


4 



24 

2 

4 



40 4 1 35 



lead to misleading information; audited accounts of associated com- 
panies were not available; associated companies' retained earnings 
are not available for distribution; and special circumstances relating 
to associated company. 

SUMMARY 

The objectives of this paper were to outline the equity method of 
accounting for investments in common stock as applicable in New 
Zealand and to highlight some of the main differences from the pro- 
nouncements and exposure drafts of other English-speaking coun- 
tries. The author concludes that SSAP No. 2 differs from the other 
pronouncements and exposure drafts examined in some important 
areas: for example, in New Zealand, the equity method is currently 
considered appropriate only for the preparation of consolidated state- 
ments but not for accounting entries in the books of the investor as a 
legal entity. The international comparison of pronouncements and 
exposure drafts revealed disagreements in certain areas, such as the 
proportion of unrealized profits to be eliminated on intercompany 
transfers. 

Interviews with executives of forty-one corporations in New 
Zealand listed on the Stock Exchange revealed that the requirements 
of SSAP No. 2 were not always uniformly interpreted in practice. 
However, only in a few cases was there a fundamental departure from 
the requirements of SSAP No. 2 where associated companies were 
either fully consolidated (similar to subsidiaries) or accounted for on 
an equity basis in the books of the investor. 

Corporations in New Zealand are rather small on an international 
scale: there are no corporations comparable to the international 



128 INTERNATIONAL JOURNAL OF ACCOUNTING 



giants, and intercorporate investments which fall into the category of 
associated companies are not generally significant. Only 48 percent of 
the 235 corporations surveyed did state that they had associated 
companies, but only 31 percent did apply equity accounting. Of these 
31 percent, a large proportion had only one or two associated com- 
panies which could in many cases have been ignored as not being 
material. 



Accounting Information and the Development 
Planning Process in Kuwait 

SHUAIB A. SHUAIB* 



Accounting has two functions for macroeconomic purposes: as a 
device to gather data, and (2) as a tool to implement national 
economic policies. Accordingly, sound accounting practice can con- 
tribute substantially to the achievement of the objectives of the 
national economic plans of developing nations. 1 

This study investigates the information requirements of the devel- 
opment planning process in Kuwait and identifies areas where 
improvements in accounting practices are needed to facilitate the 
attainment of national economic goals. Although the study is pri- 
marily concerned with the state of Kuwait, the author hopes that 
other developing nations with similar economic conditions, such as 
the Gulf states, can use the findings to reassess the role accounting 
plays in the formulation and implementation of their national 
development plans. The development planning process covered here 
describes the situation in Kuwait. The development planning process 
can be broadly defined as the determination of an optimum develop- 



*Shuaib A. Shuaib is the chairman of the accounting department at the University of 
Kuwait. 

'See Gerhard G. Mueller. International Accounting (New York: Macmillan Company, 
1967), pp. 3-30; Belverd E. Needles, Jr., "Implementing a Framework for the Inter- 
national Transfer of Accounting Technology," International Journal of Accounting 
(Fall 1976):45-62; Wesley T. Andrews and Charles H. Smith, "A Role for Financial 
Accounting in National Economic Planning in the United States." International 
Journal of Accounting (Fall 1976): 133-45; and Merrill E. Cassell, "Economic Devel- 
opment Accountancy, " Management Accounting — Journal of the Institute of Cost and 
Management Accountants (May 1979): 23-24. 



130 INTERNATIONAL JOURNAL OF ACCOUNTING 



ment path for a country's economy. The implications of the process 
will be different from one country to another since the ways in which 
the plan is prepared and executed vary between countries. In some 
countries, economic development plans are mandatory, while in 
others they are only consultative. There is no single formula which 
can be applied to all countries since the economy of each country has 
its own peculiar structural characteristics. Kuwait's development 
planning is mandatory for the public sector but only serves as a guide 
for the private sector. 

Planners in Kuwait are faced with two economic policy problems. 
One is finding the best investment opportunities for the country's 
substantial savings. The other problem is how best to expand the 
opportunities for investment within the country, given the limited 
availability for skilled labor and locally produced materials. 

During the course of this study, much information and perspective 
was obtained through an informal process of contacts and interviews 
with public officials and professional accountants in Kuwait. Library 
research provided background information on accounting and the 
economic development planning process. The stage of development 
and usefulness of the accounting structure in developed countries was 
used as a guide, whenever appropriate, to identify the information 
requirements of Kuwait's development planning process and as a 
frame of reference to evaluate the contribution accounting could 
make to the development planning process in Kuwait. Other infor- 
mation pertinent to the study was gathered from publications of the 
Ministry of Planning, the Central Bank, the Ministry of Finance, and 
the Ministrv of Commerce and Industrv. 



DEVELOPMENT PLANNING PROCESS IN KUWAIT 

Economic development planners in Kuwait have a difficult task in 
formulating a national plan since they are concerned not only with 
maximizing national income in a given period, but also with many 
other factors which help to achieve a balanced growth. Kuwait has 
not fettered itself by the constraints of over-specific development 
plans: a substantial part of the national revenues has always been 
channeled to the creation of social and capital infrastructure and the 
development of industry, although this has been accomplished pri- 
marily through allocations in the annual budgets. The first Five- Year 
Plan was for the period 1967-68 to 1971-72, and in 1976, the Planning 
Board (now Ministrv of Planning) completed the second Five- Year 



Accounting Information m Kuwait 131 



Plan for the period 1976-77 to 1980-81. 2 For example, the first Five- 
Year Plan in Kuwait had the following objectives: 

1. The achievement of a compound rate of growth in the national 
income of 6.5 percent per annum; 

2. The diversification of economic activity; 

3. The development of Kuwait's human resources through extended 
education and by raising the level of labor skills through intensified 
vocational and technical training; 

4. Expansion of the basic infrastructure economic projects; 

5. Attainment of a more equitable distribution of income; and 

6. The establishment of closer and better coordinated economic links 
with other Arab countries. 3 

Almost any development planning process can be divided into 
three stages: the macro (aggregate) stage, the sectorial stage, and the 
project stage. 4 At the macro stage, the planners determine a target rate 
of growth for the whole economy. Next, planners compute the 
capital-output and the labor-output ratios. These two ratios are also 
called the marginal or incremental capital-output ratio and the 
marginal or incremental labor-output ratio. These ratios indicate the 
amount of capital formation necessary to produce a unit increase in 
gross domestic product. In general, this means the ability of one 
additional increment of the factor in question to increase the total 
output. 

Given the incremental capital-output ratio and the target rate of 
growth, the investment requirement for the period can be determined. 
The determination of a realistic investment target depends on the 
reliability of the methods used to determine gross national produce 
and gross capital formation. The question now arises as to the 
reliability of these figures and how sound accounting techniques can 
contribute to making them more reliable. 

Estimates of Gross National Product in Kuwait 

The first attempt to estimate the gross national product (GNP) of 
Kuwait was made in 1961 bv the International Bank for Reconstruc- 



2 The Economist Intelligence Unit Ltd., Quarterly Economic Reinew of Kuwait 

(Annual Supplement 1978): 27-28. 

3 The Planning Board, The First Five Year Dex>elopment Plan 1967-68 to 1971-72 

(Kuwait: Government Printing Press, 1968) (hereafter cited as the Plan 1967-68 to 1971 - 

72). 

^Brian Van Arkadie and Charles R. Frank, Jr., Economic Accounting and Dei>elop- 

ment Planning (New York: Oxford University Press, 1969), p. 332. 



132 INTERNATIONAL JOURNAL OF ACCOUNTING 



tion and Development (IBRD) mission. The IBRD estimated the 1959 
GNP at approximately 296 million Kuwaiti Dinars (KD). 5 A similar 
estimate for 1962 to 63 was KD 370 million, indicating a growth rate 
of about 8 percent a year. 6 The estimates were considered approxi- 
mations because only limited statistical data were available for use 
and no distinction was made between estimates in market prices and 
in factor costs. 7 

In 1962, the Planning Board began to estimate the GNP and its 
distribution by types of expenditure. The estimates were also con- 
sidered approximations, especially for fiscal years 1962 to 63, 1963 to 
64, 1964 to 65, and 1965 to 66 because theavailablestatistical data only 
allowed approximate estimates of the national accounts. 8 

A study published by the Kuwait Institute of Economic and Social 
Planning in the Middle East indicated that the data available did not 
permit the preparation of a comprehensive system of national ac- 
counts. 9 Nevertheless, the study estimated some of the more im- 
portant aggregates, such as gross domestic product and gross national 
product, at market price, and by type of expenditures. 

Exhibit 1 reports the national income estimates for the period 1962- 
63 to 1966-67 with no distinction between factor costs and market 
prices. Exhibit 2 provides national accounts estimates at current price 
for the period 1967-68 to 1969-70. Net national product and income 
data are given in exhibit 3 while exhibit 4 reports capital and savings 
for the period 1970-71 to 1975-76. 

The Status of the Accounting Profession in Kuwait 

The accounting profession in Kuwait is still in its infancy. The first 
statute to regulate accounting was enacted in 1962. It was a necessary 
first step for the orderly development of the accounting profession. 
This law did not, however, treat accounting in a comprehensive 
manner. Another significant act of legislation which has had an effect 
on accounting in Kuwait is the Law of Commercial Companies (Law 
No. 15 of 1960). It provided the legal basis for corporate financial 
reporting and at the same time required each company to appoint an 



5 As of August 1979, the exchange rate was DLR 3.60 per 1 KD. 

The International Bank for Reconstruction and Development, The Economic Deiel- 

opment of Kuwait (Baltimore. Md.: Johns Hopkins Press. 1965). pp. 2-3 (hereafter cited 

as IBRD.. 

7 IBRD. p. 164. 

8 rhe Planning Board. Survey of Economic Conditions in Kuwait 1963-64 to 1967-68 

(Kuwait: Al-Rissalah Press, 1968). p. 29. 

9 Sivasubramanian and Abdulla M. Ali, National Accounts of Kuwait 1965-66 to 1967- 

68 (Kuwait: Moghawi Press. 1969). 



Accounting Information in Kuwait 133 



Exhibit 1. National Income Estimates (In millions K.D.) 

1962 1963 1964 1965 

1963 1964 1965 1966 



1966 
1967 



1. Consumption 
Private 
Public 

2. Gross fixed capital formation 
Private and semi-private 
Public 

3. Increase in stocks 

4. Expenditure on consumption 
and gross capital formation 

5. Export excluding oil and oil 
products FOB 

6. Export of oil and oil products 
FOB 

7. Expenditure on gross domestic 
product and imports 

8. Less imports of goods and 
services 

9. Expenditure on gross domestic 
product 

10. Net factor income transactions 
with the rest of the world 

11. Expenditure on gross national 
product 

12. Less depreciation 

13. Net national product or national 
income 



268 


281 


302 


303 


330 


188 


192 


200 


198 


210 


80 


89 


102 


105 


120 


78 


92 


96 


113 


137 


45 


47 


49 


70 


73 


33 


45 


47 


43 


64 


7 


3 


3 


7 


13 


353 


376 


401 


423 


480 


8 


10 


12 


15 


21 


414 


434 


468 


490 


505 


775 


820 


881 


928 


1006 


122 


-141 


-141 


-176 


-208 


653 


679 


740 


752 


798 


-193 


-179 


-198 


-187 


-196 


460 


500 


542 


565 


607 


-19 


-25 


-28 


-34 


-36 



441 



475 514 



531 



571 



Source: The Planning Board, Sunry of Economic Conditions in Kuwait, 1963-64 to 1967-68, p. 130. 



auditor. The third statute which has affected accounting in Kuwait is 
the Law of Commerce (Law No. 2 of 1961) which stipulated the 
requirement for the commercial books of the business. In all cases, the 
firm is obliged to keep at least two books, the daily journal and the 
inventory book. 

These laws have influenced the development of accounting and 
increased the volume of accounting work for both the companies and 
the accountants of Kuwait. On the other hand, the rigidity specified 
by the provisions of these laws contributed to the slow development of 
the accounting profession. 

The Kuwaiti accounting profession is still without a uniform body 
of generally accepted auditing standards and a statement of generally 
accepted accounting principles. In addition, no code of professional 
ethics has been developed. Kuwaiti accounting practice is derived 



134 INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 2. Kuwait: National Accounts Estimates at Current Market Prices 
1967-68 — 1969-70 (K.D. Million) 

Fiscal year ending March 31 1967,68 1968,69 1969,70 

1. Private consumption 

2. Public consumption 

3. Gross fixed capital formation 

(a) Public sector 

(b) Private and semi-private sectors 

4. Net change in stocks 

5. Exports of goods fc services 

(a) Exports excluding oil & oil 
products, f.o.b. 

(b) Exports of oil & oil products, f.o.b. 

6. Imports of goods and services 

7. Gross Domestic Product (GDP) 
at market prices 

8. Indirect taxes less subsidies 

9. GDP at factor cost 

of which value added by: 

10. Agriculture & fisheries 

1 1. Oil & natural gas 

12. Manufacturing 

13. Construction 

1 4. Electricity, gas, water & sanitary services 

15. Transportation, storage & 
communications 

16. Wholesale & retail trade 

17. Banking, insurance & other financial 
services 

18. Ownership of dwellings 

19. Public administration 8c defense 

20. Services 

21. Net factor income transactions with 

the rest of the world -138 -158 -147 

(a) Factor income transfers by conces- 
sionary oil companies (-220) (-248) (-251) 

(b) Income on government foreign assets 
(inc. KFAED and the Central Bank) 

(c) Income on commercial banks' assets 

(d) Income on private investment (net) 

22. Gross National Product (GNP) at 
market prices (7 + 21) 

23. Capital consumption 

24. Net national product or national income 
at factor cost (8 + 22 + 23) 



280 


297 


303 


135 


144 


153 


163 


154 


151 


(68) 


(54) 


(62) 


(95) 


(100) 


(89) 


23 


17 


19 


519 


587 


630 


(21) 


(28) 


(33) 


(498) 


(559) 


(597) 


-248 


-248 


-269 


872 


951 


987 


- 4 


- 4 


- 4 


868 


947 


983 


5 


5 


5 


474 


530 


557 


34 


37 


36 


43 


42 


39 


28 


31 


36 


30 


33 


35 


80 


84 


85 


15 


17 


18 


45 


47 


44 


50 


52 


55 


64 


69 


73 



(28) 
(18) 
(36) 


(30) 
(21) 
(39) 


(41) 
(23) 
(40) 


734 


793 


840 


-42 


-45 


-50 


688 


744 


786 



Accounting Information in Kuwait 135 



Exhibit 2. (cont.) 



!3 


133 


138 


9 


9 


9 


13 


206 


213 



Fiscal year ending March 31 1067,68 1968,69 1969,70 

of which: 

25. Compensation of employees 183 195 208 

26. Income from farms, professions and other 
unincorporated enterprises received by 

households 85 93 96 

27. Income from property received by 
households and private nonprofit 
institutions 

28. Saving of corporations 

29. Direct taxes on corporations 

30. General government income from 

property and entrepreneurship 109 112 128 

31. Less interest on public debt — — — 

32. Less interest on consumers' debt - 4 - 4 - 6 

Source: The Planning Board. The Kuwait Economy 1969 to 1970, (Kuwait: Kuwait Government 
Press, 1970). pp. 14-15. 



from American and European practices. So far, nothing has been 
done to develop accounting principles and auditing standards and 
procedures specifically applicable to the legal and economic environ- 
ment of the state of Kuwait. 

RELATIONSHIP BETWEEN DEVELOPMENT PLANNING PROCESS, 
NATIONAL INCOME, AND ACCOUNTING 

There are organic and conceptual relationships between national 
income and accounting. These relationships have been recognized by 
an American Accounting Association (AAA) study: 

The national income and product accounts and the national balance sheet 
are comparable to enterprise accounting's income statement and balance, the 
flow of funds account compares to the statement of changes in financial 
position. 10 

The calculation of national income in Kuwait was unreliable until 
1966 because of limitations in the statistical data" which can be seen 



10 Committee on International Accounting Operations and Education 1976 to 78, 
Accounting Education and the Third World (American Accounting Association. 
1978). p. 9 (hereafter cited as the AAA Study, 1978). 

"In 1962, the Central Office of Statistics was established and conducted a number of 
studies and surveys. The information provided by these studies has somewhat im- 
proved national income estimates. 



136 INTERNATIONAL JOURNAL OF ACCOUNTING 



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138 INTERNATIONAL JOURNAL OF ACCOUNTING 



in exhibit 1. Exhibit 2 includes more detailed data and provides a 
clearer picture of the dependence of national income accounting on 
business accounting. Many items in exhibits 1, 2, 3, and 4 can be 
derived directly or indirectly from business reports. Some examples 
which substantiate this assertion follow. In exhibit 1, items 2 (gross 
fixed capital formation), 3 (stocks), and 4 (expenditure on consump- 
tion and gross capital formation) are based on business accounting 
reports. Moreover, the national product data (exhibit 3) are derived 
largely from the business reports. 

In addition, questions can be raised as to the reliability of these 
figures. For example, it appears that the depreciation figures are 
defective in three respects. First, the method used to determine the 
amount of depreciation had the depreciation amount in the plan as 
KD 80 million in base year net national fixed assets. "In reality, this 
was an informed guess based on the assumption that fixed capital 
depreciates in Kuwait at the rate of 10 percent per annum; . . ." 12 
Second, the amount of depreciation is based on historical cost. Third, 
because of lacks in managerial and technical skills, improper use by 
labor causes the actual rate of damage to fixed capital to be greater 
than usual. This abnormal damage should have been included in the 
depreciation figure. 

Another question can be raised as to the reliability of the stocks 
(inventory) amounts representing the changes in stocks. Data on the 
quantity and value of stocks of various commodities held and of their 
changes over time do not exist in Kuwait. Estimates are therefore 
nothing more than informed guesses. 13 These amounts, then, are not 
computed from individual business reports but are only estimates. 
Price-level changes are also ignored. 

"To better allocate scarce human, financial and material resources, 
all countries require some form of economic planning or pro- 
gramming." 14 Sound accounting could improve the reliability of 
planning at the macro stage by providing more realistic information. 
For example, the planners in this stage determine the amount to be 
invested to achieve the targeted rate of growth. This means the 
planners must compute the capital-output ratio. The reliability of 
this ratio depends on the reliability of the investment and national 
product data. The more accurate these figures, the more realistic the 
amount to be invested to attain the target rate of growth. As stated 
earlier, these amounts are based on accounting information. Thus 



12 The Plan, 1968-69 to 1971-72, p. 44. 

13 Sivasubramanian and Ali. National Accounts of Kuwait, p. 44. 

M The AAA Study, 1978. p. 11. 



Accounting Information in Kuwait 139 



this ratio will depend on the reliability of the accounting data and the 
accurate classifications. In computing the capital-output ratio, 
Enthoven recognized that 

Capital output ratios, reflecting the quantities of output resulting from a 
unit of capital input are used as either measuring or policy-making devices in 
micro and macrodevelopment programming. In the microsphere they por- 
tray the resulting national income from capital investment — again largely 
based upon industry (accounting/statistical) data. In computing the gross 
net or marginal capital output ratios, the "value" and composition attached 
to capital equipment, depreciation and output are of vital concern. Capital 
outputs or value outputs should be included or excluded according to 
realistic accounting information and classification. 15 

Another area in which accounting reports can be useful is the 
determination of the amount of saving in society. If financial ac- 
counting reports are reliable and realistic, the amount of saving could 
be computed from business financial accounting reports. The re- 
tained earnings represented in the income statements of the indi- 
vidual firm could be used as a basis for the computation of the 
national income savings needed to achieve the target rate of growth. 16 

Many terms used by the economic development planners in Kuwait 
should be clarified. "The main problem has been reconciling the 
inconsistencies between data series from different sources." 17 For 
example, in exhibit 1, item 12 is called "depreciation" and in exhibit 
2, item 23 is called capital "consumption." Apparently, both figures 
refer to depreciation. 

SUMMARY AND RECOMMENDATIONS 

This paper has addressed the relationship between accounting and 
development planning process of an emerging nation such as Kuwait. 
The discussion identified certain areas in which accounting can 
facilitate the development planning process in Kuwait. At the macro 
stage, the planners determine a target rate of growth for the whole 
economy. The determination of the growth rate requires the calcula- 
tion of incremental capital-output ratio, saving, and the percentage 
of gross national product to be invested to achieve the target rate of 



15 Adolph J. H. Enthoven, "Accounting and Development Programming," Inter- 
national Journal of Accounting (Fall 1967): 1 13; also for more discussion on capital 
output (capital coefficient), see idem.. Accountancy and Economic Development 
Policy (Amsterdam: North Holland Publishing Company, 1973). pp. 156-60. 
l6 Ralph V. Lucano. "Relationship between Financial and National Income Account- 
ing," Federal Accountant (March 1962): 17. 

"Report prepared by Stanford Research Institute, Social and Economic Impacts of the 
Kuwait Government Compensation Increase of 1971-1972 and Recommended Na- 
tional Compensation (Menlo Park, Calif.: Stanford University, 1973), pp. B-7. 



140 INTERNATIONAL JOURNAL OF ACCOUNTING 



growth. All these concepts are largely based on accounting data. 
National income accounts are concerned with measuring the eco- 
nomic performance and progress of a nation. The national income 
accounts are based, to a significant extent, on accounting information. 

Financial accounting reports represent a basic source of informa- 
tion in the quantification of these aggregate concepts. Therefore, if 
the financial accounting information at the individual firm reports is 
defective and unrealistic, then the aggregate data will show the same 
deficiencies. 

The development of the accounting profession in Kuwait is still in 
its infancy. There is no code of professional ethics, generally accepted 
accounting principles, or auditing standards. This suggests that the 
information available from business reports does not fulfill the 
information requirements of the development planning process in 
Kuwait. 

Since development planning process requires, among other things, 
a better organized accounting profession, it is recommended that: 

1. To meet the challenge of the development planning process in 
Kuwait, an organized accounting profession must exist. The account- 
ing profession has a tremendous opportunity to help speed the 
process and to establish itself in society as the protector of the public 
interest. The profession should take the lead in analyzing the account- 
ing principles and auditing standards and procedures which are 
presently used. Such an analysis would contribute to the subsequent 
codification of acceptable accounting practices in Kuwait. 

2. To be effective, acounting terms and concepts and their definitions 
must be clarified throughout the planning process in Kuwait, at both 
the micro and macro levels. A clarification of accounting concepts 
will facilitate and enhance the understanding of the users of the 
national accounts. 

3. A study of the information needs of development planning process 
should be undertaken. This type of study requires the identification 
of measurable goals and objectives, quantification procedures, and 
the application of evaluation procedures, such as planning, pro- 
gramming, a budgeting system, and zero-base budgeting. Sound 
economic development accounting is vital to the development planning 
process in Kuwait. The introduction of economic development ac- 
countancy will facilitate the establishment of an effective govern- 
mental system equipped with capable managers and accountants. 
The need for economic development accountancy was recognized by 
the AAA study: 



Accounting Information in Kuwait 141 



To cater effectively to the needs of socioeconomic development, a distinct 
body of knowledge called economic development accountancy may be re- 
quired. Economic development accounting can be described as the applica- 
tion of existing and potential accounting systems, techniques, procedures 
and data to enhance economic development within a nation and among 
nations. 18 

4. To meet the information needs of the development planning 
process in Kuwait, the government must establish a comprehensive 
information system for the storage and retrieval of financial, mana- 
gerial, economic, and technical data related to the planning process. 
This system would enable governmental units to monitor the plan, 
exercise coordination and control, and measure performance. Also, it 
would profide information needed for planning process. 

5. Effective uniform accounting standards can provide accurate, 
comparable, and reliable information for policy makers in economic 
sectors to make optimal decisions. Uniformity of presentation could 
improve the national accounts. The normative concept of uniformity 
may be desirable in Kuwait. However, uniformity should be ac- 
companied by continuing review and evaluation. It should retain the 
flexibility necessary to respond to economic changes. 



i»The AAA Study 1978, p. 20. 



The Role of Accounting in Project Evaluation and 
Control: The Syrian Experience 

ADNAN ABDEEN* 



Accurate and reliable information is necessary for the successful 
planning and controlling of economic activities in both developing 
and developed countries. It is the function of the accountant to select 
the relevant aspects of economic events, organize and summarize 
them, and subsequently report them for further use by interested 
parties. The economist is likely to use accounting techniques for 
different problems for which data are marshalled. 1 

The traditional concern of the field of accounting has been to 
provide historical financial data of economic activities. In recent 
years, the trend has been to emphasize the economic decision-making 
function because of the utilization of the accounting data for 
planning and projecting future economic activities. 2 In several 
countries (for example, France and Germany), the emphasis of the 
accounting process has shifted even further toward the national 
economic goal orientation. Several developing countries have 
adopted standardized accounting systems for business enterprises. 3 
These systems may remedy the problem of deficient and disorganized 
economic and financial data which exist in the developing countries. 



•Adrian Abdeen is chairman of the MBA Program, College of Industrial Management, 

University of Petroleum and Minerals, Dhahran, Saudi Arabia. 

The author is indebted to Dr. Dora Herringof Mississippi State University for valuable 

comments on an earlier draft. 

'B. Van Arkadie and C. Frank, Economic Accounting and Dei'elopment Planning 

(London: Oxford University Press, 1966), p. 3. 

2 Yuji Ijiri, "Critique for the APB Fundamental Statement," Journal of Accountancy 

(November 1971): 45. 

3 Adolf J. H. Enthoven. "Standardized Accountancy and Economic Development," 

Finance and Dei'elopment (March 1973): 31. 



144 INTERNATIONAL JOURNAL OF ACCOUNTING 



In most of these countries, the economists usually assume the respon- 
sibility of performing the role of policy advisors and planners or 
economic activities. The subject of business accounting, interindustry 
accounting, and social-national accounting techniques is of interest 
to these economists because they are faced with many decisions that 
demand the use of various accounting techniques for their solutions. 
This paper focuses on the role of accounting techniques and 
practices in the evaluation of capital investment decisions. It intro- 
duces the reader to the evaluation and decision-making process used 
to select industrial projects as practices in the developing country of 
the Syrian Arab Republic. The extent of involvement of accountants 
and accounting techniques in the planning and control of industrial 
projects included in the Syrian economic plan is also discussed. 

ACCOUNTING AND PROJECT APPRAISAL 

The World Bank has interpreted projects to mean proposals for 
capital investment to develop facilities to provide goods or services. 4 
The investments may consist of building entirely new facilities or the 
expansion or modernization of existing ones. The techniques of 
project appraisal are equally applicable to the preparation of data 
and the assessment of projects by private businesses or government 
agencies in all countries, including the developing countries. 5 Project 
appraisal is an important element in the formulation of coherent 
economic programs that comprise the framework for the country's 
economic development activities. Because of the lack of capital in 
most developing countries, investment decisions should consider 
economy and efficiency. Drawing on the experience of the World 
Bank, in appraising a project, the Bank's officials are rather skeptical 
of the information related to any project proposed to them for loan 
consideration. This skepticism is applied to economic, technical, 
institutional, and financial aspects of the project appraisal, begin- 
ning with a questioning of the basic statistical data to ascertain that a 
false sense of accuracy is not reached through the application of 
sophisticated techniques of analysis to questionable basic data. 6 

When appraising the feasibility and justification of projects and 
their components, extensive use of past, present, and future data is 



4 John A. King. Jr., Economic Development Projects and Their Appraisal (Baltimore, 

Maryland: Johns Hopkins Press. 1967). p. 3. 

*Ibid., p. 4. 

6 Hugh B. Ripman. "Project Appraisal," Finance and Dei'elopment (December 1964): 

178.' 



Syrian Accounting: Project Evaluation/ Control 145 



made. The cost-benefits calculations require information which is 
often based on historical data modified for economic and price 
changes. The historical data are based on accounting techniques, a 
knowledge of which is important to assess its usability. Furthermore, 
the information should be economically realistic and have compre- 
hensive standardized content. For example, the use of tables for 
standardized labor inputs per production process, raw material re- 
quirements, power, and fuel needs for each scale of output and 
installation cost would be recommended. 7 

To investigate the project from all aspects, the need for experts in 
many fields becomes apparent. The cooperation of economists and 
accountants is of utmost importance, because they are in a unique 
position to understand the methods and techniques used in the 
accumulation of the information. They are also able to relate and 
analyze the data, not as related to the feasibility and profitability of 
the project itself, but as they fit into the overall development plan of 
the country. It is unfortunate that the supply of skillful economists 
and accountants in the developing countries is limited. 

The economic aspect of project appraisal involves the question of 
priorities in the economy. The analysis of the economy provides 
reasonable estimates of the general level of future requirements for 
goods and services, and thus indications of the relative priorities of 
various projects are indicated. This aspect also involves the justifi- 
cation of the use of scarce resources needed for economic development 
such as investment capital, managerial talent, skilled labor, and the 
like. This aspect also requires the study of the market demand for the 
goods and services to be provided by the project. 

The first indication of economic justification of a project can be 
determined by calculating its commercial profitability and by finding 
the effect of the project on the balance of payments of the country. 
The latter aspect is very important in a country that suffers from 
shortages of foreign exchange. The commercial profitability involves 
the application of accounting techniques and principles to arrive at 
the annual net income from the operations, often referred to as the 
accounting income. Once the estimated annual accounting income 
over the life of the project is determined, then the accounting methods 
for evaluation of investment in projects can be utilized. These methods 
are the payback period, the average return on investment, the present- 
value method, and the discounted cash-flow method. The discounted 



'Enthoven, "Standardized Accountancy and Economic Development," p. 30. 



146 INTERNATIONAL JOURNAL OF ACCOUNTING 



( ash-flow method is more promising than the other methods, which 
are considered to be crude approximations of profitability of 
investments. 8 

Commercial profitability of the project is not a sufficient criterion 
t( )i the evaluation of projects. The national economic profitability is 
of vital importance and should be considered. Such importance arises 
from three sets of factors. 9 First, the market mechanism in developing 
countries (and even in developed countries) does not always reflect 
relative scarcities. Such scarcities relate to the true social costs of 
vai ious inputs which make the market prices unreliable when arriv- 
ing at the materials cost of the project. The market wage rate, used in 
arriving at the total wage cost of the project, does not accurately 
reflect social opportunity cost of labor in countries where there is a 
surplus of labor. Furthermore, the prevalent rate of interest often does 
not reflect the relative scarcity of capital, that is, the productivity of 
capital investment. 10 Secondly, commercial profitability does not 
necessarily consider the rate of growth of the national economy, the 
expansion of employment opportunities, and the reduction of in- 
equality among various income groups and regions. 11 Third, the rate 
of interest in any country supposedly reflects the time preference of 
that country, attaching relative weight to present consumption com- 
pared with future consumption. The fact is, however, that conditions 
of perfect competition are not found in any country, least of all in 
developing countries. In addition, the decision as to the social time 
preference between present and future consumption cannot be left to 
the market mechanism in most of the developing countries seeking to 
accelerate economic development. 12 

The commercial profitability aspect of the appraisal lends itself 
easily to quantitative measurements and so, to a lesser extent, the 
national economic profitability. There are other important economic 
considerations, however, that are not entirely measurable, such as the 

8 A. Alfred and J. B. Evans. Appraisal of Investment Projects by Discounted Cash 
(London: Chapman and Hall, 1971), p. 2. 

'United Nations, Bureau of Technical Assistance Operations, Report of the Inter- 
regional Symposium on Industrial Project Evaluation (ST/TAO/SER.C/82), 1966, 
pp. 5-6. 

10 Ibid.; as far as interest charges are concerned, the problem in the accounting method is 
even more unreliable because accountants include in the total costs and expenses only 
interest charge on loans where the economists include interest charges on the entire 
< apital invested, recognizing the opportunity cost involved. For comparison between 
the accounting and economic costs, see Micha Gisser, Introduction to Price Theory 
(Scranton, Penn.: International Textbook Company, 1966). pp. 102-4. 
"United Nations, Report of the Interregional Symposium, pp. 5-6. 
'-Ibid. 



Syrian Accounting: Project Evaluation Control 147 



interindustrial aspects of the project. These include the cost of sup- 
porting or servicing facilities, such as transport and power, and on 
the benefit side, they include the benefits derived from the project in 
terms of using its output as needed input of other industries or sectors 
of the economy. Furthermore, the new project may generate new 
economic activities linked to existing or proposed economic units. 

In addition to the preceding considerations, the appraiser considers 
the examination of the vital aspects of financing the project during 
the construction period as well as during the period of operations. 
These may include the domestic or foreign sources and application of 
funds, the liquidity of the business, and the capital structure. The 
determination of the required working capital during the construc- 
tion and operations stages is very important to spare the project from 
serious difficulties such as delays, loss of skilled labor, excessive costs, 
and other difficulties due to shortages of funds. Such an analysis also 
helps to formulate the plans for short-term financing, an issue that is 
relevant even when the project is financed by government through its 
lending agencies. Exploration of several domestic and foreign finan- 
cial institutions will follow to secure the best credit terms possible. 
The economist who appraises the project, as well as the official of the 
lending institution who reviews and appraises it, usually has many 
questions to ask about the basis of the projected data included in the 
project study. When the project deals with an expansion or addition 
to an existing industry, some of the amounts included in the financial 
projections are based on previous experience depicted in the past 
financial statements prepared by the accountant. However, when the 
project is entirely new to the country, the data are based on the 
experience of other countries and supplied by foreign experts or by 
local engineers who make the technical evaluation. Ripman has 
cautioned the evaluator of a project, when examining its financial 
aspects, to examine the proposed financial statements. He has raised 
several questions regarding the financial statements, such as what 
accounting method is used in valuing the fixed assets; what method 
or methods of depreciation are used; how much of the profits are 
distributed and how much are reinvested; whether inventories are 
valued conservatively; whether there are unlisted or contingent lia- 
bilities; and whether there are any hidden reserves not appearing on 
the balance sheet. 13 

The accounting practices and techniques play, then, an important 



3 Ripman, "Project Appraisal," pp. 182-83. 



148 INTERNATIONAL JOURNAL OF ACCOUNTING 



role in project planning. This role is extended further to managerial 
control and decision-making aspects of the operations to follow. The 
acceleration of economic growth depends on the success of these 
planned projects. 

The other aspects of project appraisal are beyond the scope of this 
research; however, it is important to note that most of the other 
aspects have financial implications. The coordination of all aspects 
of the project is definitely that of leading the project to a successful 
start and of culminating in a meaningful and efficient operation that 
leads to a successful implementation of economic plans. 

The comments just presented are, by necessity, oversimplified and 
limited to the role of accounting in the economic and financial 
evaluation of capital investments. They do not reflect fully the 
complexity of the process of project appraisal. The application of the 
techniques involved in the process may differ from country to country 
but the general principles thereof do not. Such a process is examined 
next as it applies to the evaluation of projects included in Syria's 
economic plans. 

PROJECT APPRAISAL IN SYRIA 

Industrialization is accomplished by either introducing new large- 
scale industrial projects or through the modernization or expansion 
of existing industries. However, there are several constraints placed 
on industrial development, such as the scarcity of capital, tech- 
nicians, managers, and foreign exchange. These constraints make the 
selection of projects a crucial element in the process of accelerating 
economic growth. Industrialization is an important facet of eco- 
nomic development in Syria because it provides employment for the 
unemployed surplus workers in agriculture, raises the standard of 
living of the masses, and assures the full utilization of the country's 
productive resources. 14 The success of industrialization in Syria and 
the achievement of the highest return possible on investment in 
industrial projects is dependent on the proper selection and imple- 
mentation of projects by the organizational structure for planning; 
control which will be introduced first, and then the process of project 
appraisal will be described and evaluated. Moreover, the involvement 
of accountants and accounting techniques in the planning and 
control of projects is explained. 



"Business Institutions Graduate Association, The Second Conference on Mobilization 
of Economic Resources for Dei>elopment and Defense (in Arabic) (Damascus: Tarabishi 
Press, 1971), p. 406. 



Syrian Accounting: Project Evaluation Control 149 



THE ORGANIZATIONAL STRUCTURE FOR ECONOMIC PLANNING AND CONTROL 

In Syria, the function of preparing detailed studies of the proposed 
projects, as well as the follow-up on implementation of these pro- 
jects, is undertaken by small planning units attached to and under the 
direct authority of their respective administrative, economic, or co- 
operative organization. These units are in constant contact with the 
State Planning Organization that exercises functional authority over 
them. This organization is staffed by specialists in evaluation of 
projects and in formulating the short- and long-range economic and 
social plans of the country. The proposed project studies pass through 
the State Planning Organization as they move toward final approval 
by the Supreme Planning Council, the highest planning authority in 
the country. 

The planning and control organization structure is rather complex 
and involves several organizations (see exhibit 1). All these organiza- 
tions focus their attention on the expanding public sector, but one 
must remember that most of the decisions and plans formulated by 
these organizations affect the private sector as well. 16 The private 
sector is composed mainly of retail merchants and entrepreneurs 
involved with small industries. Any entrepreneur may seek statistical, 
technical, and other information from the Ministry of Industry when 
formulating plans for the establishment of a new industry. 

THE REQUIREMENT FOR PROJECT APPRAISAL STUDIES 

The State Planning Organization has provided the planning units of 
each industry with detailed instructions and recommendations for 
the preparation of the quantitative and financial aspects of project 
studies. Each project study should include (l)a description of the 
project, (2) a statement of estimated total project cost, (3) a statement 
of estimated annual production costs and expenses, (4) a statement of 
annual revenues, (5) the present-value schedule of cash flow, and (6) a 
conclusion of the study. 16 

Description of the Project 

Description of the project includes the name of the organization 
initiating the project, the commodity to be produced, the market 
condition, and the method of distribution. The description also 



15 For details on the major functions of the planning and control organizations, see 
Adnan Abdeen, "The Role of Accounting in the Economic Development of Syria" 
(D.B.A. Dissertation, Mississippi State University, 1974), pp. 57-58. 
16 S. A. R., State Planning Organization. "Guide to Project Appraisal" (in Arabic), 
mimeographed (Damascus, 1972), p. 1. 



150 INTERNATIONAL JOURNAL OF ACCOUNTING 









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Syrian Accounting: Project Evaluation Control 151 



includes the needed machinery and materials, the annual capacity, 
the proposed location, and the required skilled and unskilled labor. 

Statement of Estimated Total Project Cost 

The statement of estimated total project cost includes a detailed 
listing of fixed and working capital needed for the project and the 
complementary investments in other projects. An examination of this 
statement revealed that there is a distinction between capital expendi- 
tures and revenue expenditures. The fixed investment cost required 
includes the tangible and intangible assets. The cost of these assets 
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tures required in obtaining and readying the assets for the purpose for 
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labor and other overhead expenditures. The latter is estimated to be the 
total annual manufacturing costs (excluding depreciation, interest, 
and the minimum required inventories) divided by the operating 
cycles of the business. The number of operating cycles is calculated by 
dividing the number of days between the date of purchase of raw 
materials and the date of sale of the finished project into 365 days. The 
total investment in the project also includes any complementary 
investment needed but not necessarily owned by the project. Fur- 
thermore, all investment outlays should be separated into domestic 
and foreign to determine the foreign-exchange needs of the project. 

Statement of Estimated Annual Production Costs and Expenses 

The statement of estimated annual production cost and expenses 
includes the cost of material and supplies, labor, and other expenses 
which include taxes, depreciation, rent, and interest. The deprecia- 
tion expense is based on the straight-line method applied to the 
historical cost of the fixed assets in agreement with the method and 
bases used in the standardized accounting system, a reporting system 
required for all public sector industries. The distinction between 
domestic and foreign funds annual outlays is also required in this 
statement. 

Statement of Annual Revenues 

The statement of annual revenues includes descriptions of the market 
(foreign and domestic), the customer, and the basis used to arrive at 
the quantities and amounts of sales and other revenues. According to 
the instructions of the State Planning Organization, the basis for 



152 INTERNATIONAL JOURNAL OF ACCOUNTING 



determining the expected selling prices should be clearly stated. 
Furthermore, the instructions indicate that sometimes it is possible to 
sell at lower prices on the foreign market in order to operate at 
maximum capacity and generate foreign exchange. 17 

The Present-Value Schedule of Cash Flow 

The financial information required for project appraisal is geared to 
the present-value method of evaluating capital investment. The 
information is included in the present-value schedule of cash flow 
which shows the flow of funds on an annual basis (see exhibit 2). 

Conclusion of the Study 

The conclusion of the study includes a statement of approval or 
disapproval of the proposed project. The approval of the project is 
dependent on its economic feasibility, which is referred to as the 
realization of surplus or excess of the present value of surplus profit 
(net cash inflow) over the present value of investment costs. 

EVALUATION OF THE REQUIREMENTS FOR PROJECT APPRAISAL STUDIES 

An examination of the instructions provided by the State Planning 
Organization for project appraisal studies reveals several important 
features. The language and style of directives and explanations are 
rather simple. Step-by-step instructions are provided to facilitate the 
work of the staff members in the planning units. Moreover, the 
terminology, formats, and account numbers are in agreement with 
the standardized accounting system. This is a very important feature 
that facilitates control once the project is approved because the actual 
accounting data supplied by the standardized system could be com- 
pared with the budgeted data. This could be done, not just during the 
construction state, but also during the operating stage. 

The statement of estimated project cost is rather comprehensive 
and appears to be adequate. However, the statement of annual 
production cost shows no distinction between manufacturing, sell- 
ing, and administrative costs and expenses. There is also no separa- 
tion of fixed and variable costs which facilitates marginal analysis, 
differential cost analysis, and break-even analysis. In addition, there 
is a possibility, as stated earlier, of selling the product at lower prices 
on the foreign market in order to operate at maximum capacity and 
generate foreign exchange. Without the knowledge of fixed and 
variable costs of production, a decision on the selling price becomes 

17 Ibid., p. 15. 



Syrian Accounting: Project Evaluation Control 153 



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rather difficult. The decision maker needs to know the contribution 
margin before lowering prices on merchandise sold on the foreign 
market. 

When computing the present value of net cash flow (surplus 
profits), taxes, production fees, depreciation, and interest charges are 
excluded from the cash outflow needed for the cost of production (see 
column 2, exhibit 2). The exclusion of depreciation is justified 
because depreciation does not require cash outflow, but the exclusion 
of taxes, production fees, and interest charges is debatable. It may be 
that these cost items are excluded because they are paid to the 
government and are considered to be transfer payments. They should 
be included, however, because in determining the feasibility and the 
profitability of the investment, the project should be considered as a 
separate entity from those who own it. Furthermore, if the project 
were financed by loans from a foreign country or loans from foreign 
financial institutions, the interest charges would not then be con- 
sidered transfer payments. 

In spite of the insufficiency of information previously mentioned, 
this method of project appraisal is an improvement over earlier 
methods used in project studies made by the planning authorities. 
For example, for the study of investment in a fertilizer plant, the 
present-value method was used. In this method, uniform cash flow 
over the life of the project and a discount factor of 15 percent were 
used. A 10 percent factor was also used for purposes of comparison. 
The planners also used the full capacity of the project in the calcula- 
tion. It is rather an optimistic view, because it must be remembered 
that the plant may suffer several starting problems and adjustments 
during the beginning life of its operations and a slowdown due to old 
machinery and equipment during the latter part of its life. The use of 
an estimated fixed selling price is not sound because it is not realistic 
to assume that any price will stay the same. This is due to probable 
shortages on the domestic or the international market or due to 
increases in the costs of production. The price may even decrease if 
new technology' is introduced that reduces the cost of production. 
Furthermore, it was assumed that the plant will sell all of its produc- 
tion. This optimistic view deviates from the reality of the market 
conditions. 

The new method of calculating the present value (as illustrated in 
exhibit 2) remedies some of the deficiencies of the earlier methods 
used in project studies such as the study of the fertilizer plant because 
the flow of revenues is not uniform due to expected fluctuations of 
sales quantities and prices. 



Syrian Accounting: Project Evaluation Control 155 



THE INVOLVEMENT OF ACCOUNTANTS AND ACCOUNTING TECHNIQUES 
IN THE PLANNING AND CONTROL OF PROJECTS 

To gain more insight into the appraisal process and to determine the 
actual involvement of the accountants and the use of accounting 
techniques in the planning and control of the proposed project, an 
interview was arranged with the assistant to the Minister of Planning 
in the State Planning Organization. Most of the following statements 
are based on this interview. 

In the planning stage, there seems to be a great degree of reliance on 
accountants and accounting techniques for the appraisal of a project 
that involves the expansion of existing industries. The Organization 
relies on engineers and/or foreign experts in evaluating the new 
projects. However, accounting techniques and principles are used in 
arriving at the expected profit and return on investment for both types 
of projects. 

To determine the revenues from a project, the quantities to be sold 
on the domestic market are estimated on the basis of income elasticity 
of demand. In some cases, this may involve the inclusion of the 
combined demand of neighboring countries because of smuggling, 
close trade relations, and movement of goods between these countries. 
In arriving at the expected selling prices, the prevailing selling prices 
on the domestic market are considered. However, the total cost of 
production is normally compared with foreign prices (excluding 
custom duties). Whenever the foreign price is lower than the pro- 
jected cost, the project may not be approved. However, if the freight 
and insurance charges were added to the foreign price and the total 
was greater, equal to, or slightly lower than the cost, the project may 
be approved. 

Whenever the cost exceeds the revenues from the projects, other 
social benefits may be considered. The accounting profit is empha- 
sized when appraising a project, but it does not dominate the de- 
cision. For example, for the projects included in the third five-year 
plan, the accounting profit was used in appraising and justifying the 
capital investment. 18 

To analyze the project, some other economic bases are used to 
supplement the accounting profit criteria. 19 These bases include the 
following items. First, they include the ratio of the total increase in 
national income from the project to the total capital invested in the 
project. This ratio indicates the degree of dependence on capital 



18 Business Institutions Graduate Association, The Second Conference, p. 111. 
19 Ibid., p. 412. 



156 INTERNATIONAL JOURNAL OF ACCOUNTING 



rather than on labor. In addition, the period needed for completing 
the project is determined. This period shows the length of time the 
investment funds are unavailable before funds are generated from the 
project. Moreover, the bases include ratios related to foreign- 
exchange use such as ( 1 ) the ratio of the needed foreign exchange for 
completion of the project to the total funds outlays needed for 
completion, (2) the annual savings of foreign exchange to the in- 
vested capital, and (3) the total domestic raw materials needed for 
production to the total raw materials needed for production. Finally, 
other strategic considerations, such as giving preference to the pro- 
duction of consumer goods or the production of capital goods, are 
considered. 

These ratios are helpful in assessing the effects of the capital 
investment on certain aspects of the economy. However, the crucial 
element in making the decision is the profitability of the project 
which is based on the present-value method of cash flow. In the 
calculation of the present value, the organization uses the 7 percent 
factor (see column 5, exhibit 2), but in the past, the organization used 
10 percent and 15 percent factors. 20 The 7 percent factor seems to be 
low and unreliable in this case, because all the banking and financial 
institutions in Syria are nationalized, and their interest rates are set by 
government authorities. In the case of the developing countries, 
where the return on capital investment is rather high, the discount 
factor should not be less than 15 percent. 21 

The problem of choosing an interest rate or a discount factor in a 
largely state-controlled economy is rather complex. The crucial point 
is that when screening investment projects, first priority should be 
given to those projects that yield higher net productivity. 22 As a 
solution to this problem, the method of discounted cash flow seems to 
be more meaningful than the present-value method, because the 
discount rate is not predetermined, and one can arrive at such a rate by 
trial and error method and then compare it with some standard. 
Another advantage of this method was mentioned earlier, that is, the 
ranking of projects according to their discounted rates. Projects that 
satisfy the society's wants and yield higher net productivity would 
then be selected first. After much investment has gone into these 
projects and the diminishing return has brought down the yield, then 
one can go to lower net productivity projects. 23 

20 For illustrations on the use of these factors, see Adnan Abdeen, "The Role of 

Accounting in Economic Development," pp. 69-71. 

21 Business Institutions Graduate Association. The Second Conference, p. 418. 

22 Paul Samuelson, Economics, 8th ed. (New York: McGraw-Hill, 1970), p. 580. 

23 Ibid. 



Syrian Accounting: Project Evaluation/ Control 157 



The issue of choosing the higher yield projects in Syria is more 
involved, because first priority is given to those projects that make the 
country self-sufficient in satisfying the basic needs of the people. It is 
evident from the interview that the social well-being of the people is 
greatly emphasized. However, the final decision on the proposed 
projects is reached by the Council of Ministers, which is headed by the 
prime minister, upon the recommendations of the Economic Minis- 
terial Commission. At this level, other issues are involved, such as the 
resulting tax effect of the project, the allocation of government funds 
for all projects, and the source of borrowing. All these aspects must be 
kept in mind and must fit into the overall economic and social plans 
of the country, as well as the national budget. 

Once a decision is reached on the projects, another issue is im- 
portant to the economic development. The issue involved controlling 
the expenditures for completing the projects as well as the future 
operations. Without this control, there is no way to assess the 
efficiency of planning and the professional quality of the officials 
making the decisions. It is apparent from the interview with the 
official in the State Planning Organization that studies to compare 
the estimated data of the appraised projects with the actual data are 
not made. Such studies are essential to the determination of the 
profitability of the operations and the assessment of the quality and 
efficiency of management. The two reasons given for the lack of those 
studies are the lack of a uniform system of reporting the financial data 
and the absence of reporting the financial data and the absence of 
qualified personnel to carry on the task of reliable reporting, includ- 
ing analysis and interpreting of the financial results of operations. 

According to the organization chart of economic planning and 
control, two organizations should perform the legal and financial 
control function. The General Commission for Control and Audit- 
ing should make implementation reports and submit them directly to 
the office of the prime minister. The other organization is the General 
Organization of Financial Control, which should perform the finan- 
cial auditing function and report to the Ministry of Finance. These 
two organizations are mainly staffed by personnel with a legal back- 
ground, who normally emphasize the proper documentation of the 
receipts and disbursements of funds, rather than the economic and 
financial evaluation of operations. 

The officials have great hopes of remedying this deficiency of the 
control aspect of economic activities on the standardized accounting 
system. They feel that uniform reporting will produce usable and 
dependable information that will enable them to evaluate the effi- 



158 INTERNATIONAL JOURNAL OF ACCOUNTING 



ciency of implementation of the projects and improve their planning 
and decision-making function. This feeling is not necessarily con- 
fined to the usability of the financial information in the case of 
individual firms, but also extends to the interindustries and the 
national economy. They are also hoping that accounting education 
will improve at the college level so more qualified graduates in the 
field of economics and business, especially accounting, will fill the 
gap of shortages of qualified personnel needed for economic 
planning and control at all levels and varieties of economic activities. 

CONCLUSION 

The planning authorities in Syria place great emphasis on project 
appraisal of information related to commercial profitability and flow 
of funds. Accountants in Syria seem to be involved in the appraisal of 
projects dealing with the expansion of existing industries. These 
accountants are invoked to a much lesser extent in projects intro- 
duced to the economy for the first time. Instructions provided by the 
State Planning Organization for project appraisal studies are rather 
simple and tend to facilitate the work of the staff members of the 
planning units. The requirements for project appraisal stated in 
these instructions include several statements that involve accounting 
techniques and information geared to the present-value method of 
evaluating capital investment. Furthermore, the accounts in the 
statements are in agreement with the standardized accounting system, 
a feature which facilitates control of the approved projects. 

Both accounting and economic factors are usually considered in 
the evaluation of projects. Additional criteria include the overall 
relationship of these factors to the economic and social plans, as well 
as the national budget. These criteria are, in fact, taken into serious 
consideration at higher levels of the organizational structure for 
economic planning and control. 






Instructions to Authors 159 



INSTRUCTIONS TO AUTHORS 



All manuscripts submitted for consideration should be typed on %%. x 11" 
paper and should be double-spaced throughout, including synopsis, foot- 
notes, and bibliography. At least two copies should be submitted for review. 
Margins should be appropriately wide to facilitate editing. The title of the 
paper, the author's name, rank, and affiliation, and any acknowledgments 
should appear on the first page of the body of the manuscript. All pages, as 
well as bibliography, exhibits, and appendices, should be serially numbered. 
The beginning of each paragraph should be indented. Footnotes may be 
placed either at the bottom of the appropriate page, or on a separate page. 
Each manuscript should be accompanied by a brief synopsis of the article 
explaining its international significance. 

HEADINGS 

All major headings within the manuscript should be in capital letters. They 
should not be numbered. Subheadings should be in capital and lower case 
letters on a separate line beginning at the left margin. If third-level headings 
are used, they should begin at the left margin and should end with a period. 
The text will follow on the same line immediately. 

EXHIBITS 

Each exhibit should be titled and numbered. A textual reference should be 
made to each exhibit. It would be helpful if the author would indicate by 
marginal notation where each exhibit should be placed. These instructions 
will be followed as printing practices allow. 

FOOTNOTES 

Footnotes should be numbered consecutively throughout the manuscript 
with superscript arabic numerals. Citations should not be made in brackets in 
the text. Mathematical symbols should not have footnote numbers attached. 
Entries for books should include author's name, title of the work underlined, 
and, in parentheses, place of publication, name of publisher, and date of 
publication. For journals, author's name, title of article within quotation 
marks, title of journal underlined, date of issue in parentheses, and page 
numbers should be included. Please see the following examples. 

'William A. Dymsza, Multinational Business Strategy (New York: McGraw- 
Hill, 1972). pp. 49-53^ 

2 Geoffrey Holmes, "Replacement Value Accounting," Accountancy (March 
1972): 4-8. 

BIBLIOGRAPHY 

Manuscripts may include a bibliography at the end of the paper. If so, such 
references should contain all data necessary for identification. Citations 
should be arranged in alphabetical order necessary for identification. Multi- 
ple works by the same author should be listed according to chronological 
order of publication. Examples are listed below. 



160 INTERNATIONAL JOURNAL OF ACCOUNTING 



Robert L. Aliber and Clyde P. Stickney. "Accounting Measures of Foreign 
Exchange Exposure— The Long and Short of It." Accounting Review, 
January 1975, pp. 44-57. 

American Institute of Certified Public Accountants. Accounting Research 
Bulletin No. 43. New York: AICPA, 1953. 

"Financial Statements Restated for General Price Level Changes. 



Statement of the Accounting Principles Board No. 3. New York: AICPA, 

1969. 
Leonard Lorensen and Paul Rosenfield. "Management Information and 

Foreign Inflation." Journal of Accountancy, December 1974, pp. 98-102. 
Lawrence Revsine. Replacement Cost Accounting. Englewood Cliffs, N.J.: 

Prentice-Hall. 1973. 

MATHEMATICAL NOTATION 

Mathematical notation should be stated as simply as possible so as to simplify 
typesetting. Alignment should clearly indicate superscripts and subscripts. 
Equations which are numbered should have the numbers in parentheses 
flush with the left-hand margin. 



CORRECTIONS 



Gerhard G. Mueller, author of "St. Louis to Munich: The Odyssey of the 
International Congresses of Accountants," page 1 of the Journal (Fall 1979) 
wishes to note the following concerning his article: 

"I am pleased indeed to be able to report a monumental reference error in my 
'St. Louis to Munich . . .' paper in the Fall 1979 issue of the Journal. My 
reference to the 'late' Jacob Kraayenhof of the Neatherlands was as 'greatly 
exaggerated' as the one Mark Twain corrected by cable from London to the 
Associated Press in 1897." 

Rita M. Madonado, author of "Recording and Classifying Transactions in 
the Balance of Payments" which appeared in The International Journal of 
Accounting, Volume 15, Number 1 (Fall 1979), wishes to express her deep 
appreciation for generous assistance at every stage to Jack J. Bame, associate 
director for international economics, Bureau of Economic Analysis, U.S. 
Department of Commerce; Marie Collins, report specialist. International 
Research Department, Federal Reserve Bank of New York; and Lawrence S. 
Ritter of New York University. Invaluable assistance on various points was 
also provided by David T. Devlin and Robert B. Leftwich. respectively vice 
president and assistant vice president, Economics Department, Citibank; 
Louis J. Moczar, Nancy R. Keith, and Russell Scholl, Balance of Payments 
Section, Bureau of Economic Analysis, U.S. Department of Commerce; and 
Gary A. Lee. International Capital Reporting System, U.S. Treasury. 



Journal of Business 
Finance and Accounting 

Winter 1979 Volume 6, No. 4 

Editor: /. R. P err in. University of Warwick, Coventry, U.K. 

Contents 

A Mathematical Programming Approach to 

Taxation Induced Interdependencies in 

Investment Appraisal R. H. Berry and R. G. Dyson 

Investors' Perception of Risk: 

A Re-Assessment Peter R. Blandon and C. W. R. Ward 

Capital Budgeting, Cost of Capital and 
Ex Ante Static Equilibrium 

Edward E. Williams and M. Chapman Findlay III 

Stochastic Demand and the Equity 

Capitalization Rate Michael S. Long and George Racette 

The Information Content of Dividends Hypothesis: 

Back to the Drawing Board? Paul A. Taylor 

Some Aspects of Inflation, Tax, and the 

Investing Borrower /. E. Everett and J. P. Dickenson 

The Use of Accounting Information in 

Consensus Management Teams Irvine Lapsley 

Applications of Goal Programming 

in Accounting W. Thomas Lin 

Analysis of Aspects of the Treatment of Monetary Gains 
and Losses in the Hyde Guidelines and ED24 W. H. Piatt 

Book Reviews 



Annual subscription £14.50 (U.S. $35.00) to library and business subscribers, or £ 8.25 (U.S. 
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Order through booksellers or direct from the publishers, Journals Dept., Basil Blackwells, 108 
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THE QUARTERLY REVIEW OF ECONOMICS 

AND BUSINESS 

Journal of the Midwest Economics Association 

Vol. 20 Summer 1980 No. 2 

ARTICLES 

Some Evidence on Differential Inventory Behavior in Competitive 

and Noncompetitive Market Settings Raymond S. Hartman 

45° Keynesianism, Imperfect Competition, 

and Macroeconomic Disequilibrium R. D. Peterson 

The Demand for Coffee in the United States, 1963-77 

Cliff J. Huang, John J. Siegfried, and Farangis Zardoshty 

Utility Productivity and Regulatory Incentives Carson W. Bays 

Big Business and Public Policy 

in Contemporary United States Kim McQuaid 

The Empirical Relation of Labor Force 

to Employment and Unemployment James E. Duggan 

Market Structure and Price Conduct Patterns 

in Concentrated Industries Robert F. Allen 

Future Imperfect Royall Brandis 

NOTES, BOOKS RECEIVED 

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INTASI 

International Accounting Studies Institute 
announces publication of the Third Edition of 

A BIBLIOGRAPHY 
OF INTERNATIONAL 
ACCOUNTING 



by Konrad W. Kubin 
and Gerhard G. Mueller 




First compiled in 1964 and revised in 1968, the bibliography is now 
available in a third edition (published September 1974) representing 
its continued evolution in response to apparent widespread use. During 
the process of selecting references, the authors considered the needs of 
international readers of corporate annual reports and the needs of pro- 
fessional accountants and auditors concerned with international busi- 
ness and finance activities. 

New classifications include: European Economic Community, Foreign 
Currency Translations, International Accounting Education and Re- 
search, and International Historical Aspects of Accounting. Most pre- 
1960 references were eliminated, and references through year-end 1972 
are reasonably complete. All references are in English. 



Price: $5.00 



Order from: BA Faculty Publications, DJ-10 
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management 
international 

review 



International Review for Management and Managerial 
Economics and Education 

In recent years a great deal of attention has been paid to those branches of 
learning which may have something to say to managers. While the economist 
has long shared the confidence of management, particularly in Germany, Italy, 
and the Netherlands, and while business economics and industrial economics 
have grown to be subjects in their own right, an equal interest is now arising, 
pardcularly in the English-speaking countries, in those aspects of management 
concerned with its human forces — with sociology, psychology, and the be- 
havior of organizations undergoing technological change. These are the 
domains of the so-called managerial sciences. The recognition of these as sub- 
jects in their own right is having profound effects upon the managerial out- 
look; in particular the development of formal and mathematical modes of 
thought — as in operations research — has thrown new light on the practical 
solution of many management problems. There is today a universal need to 
extend the use of these methods, but it is just as necessary that the mathe- 
matician know the practical needs of the manager as that the manager recog- 
nize the power of these new forms of analysis. What is to be desired 
throughout the field is an integrated outlook, calling for close collaboration 
between the scientists and the managers of all countries, and based upon 
sound bargaining between theory and practice. 

The magazine Management International Review would, on that account, 
claim to be the medium of exchange between practicing managers and re- 
search workers. It is devoted mainly to the nature and solution of manage- 
ment problems of business enterprises, corporations of public authorities, and 
other large-scale institutions. In addition, it gives particular attention to ideas 
and progress in the field of management education. 

Management International Review is addressed to pracdcing managers and 
acdve research workers, and it relies upon them for its published material. 
For it to develop as a medium of exchange it must first rely upon those who, 
from their experience or research, have something to contribute; it must be 
essentially the product of cooperation. 

Management International Review appears in three languages: English, 
French, and German. Each article will be published in the language chosen 
by its author. A summary will appear in the remaining languages. 

Annual subscription rate — DM 63 — including postal fees, published four 
times a year; all issues comprise at least 640 pages (size: 170 X 245mm). 

Betriebswirtschaftlicher Verlag Dr. Th. Gabler KG, 

P.O. Box 11, D 6200 Wiesbaden 1 (Federal Republic of Germany) 




Accounting in the 
Golden Age of Greece 



George J. Costouros 

Contemporary accounting theory and practice have been shaped by diverse 
economic and political influences. The increasing social importance of the 
accounting profession is indicated in many ways. In the United States, 
recent legislative studies by both houses of the Congress (the Cohen and 
Moss Reports) have examined critically the adequacy of the accounting 
profession in the United States and its present structure to service ade- 
quately its several publics. In Great Britain, the problem of severe inflation 
and the perceived inadequacies of the existing accounting reporting theory 
and practice were extensively studied by the Royal Commission and its 
findings given in the Sandilands Report. 

An understanding of the origins and subsequent development of accounting 
theory and pracdce should be of vital importance in our attempts to assess 
present deficiencies in accounting and to idendfy promising changes in 
accounting services to its constituencies in the future. An important part 
of this understanding can be obtained from thorough studies of the devel- 
opment of accounting in specific important historical periods. 

The Center considers the exploration reported in The Role of Accounting 
in the Economic Development of England 1500-1750, by James O. Win- 
jum, as a particularly useful study for the long-term evaluation of account- 
ing development. We believe that Professor Costouros has added a concise 
and useful work to this larger continuing study of accounting development. 
He has examined basic goals and applications of accounting in one of 
history's pivotal periods. We believe this is a useful addition to the small 
but valuable work concerned with the international development of ac- 
counting thought. 



Copies will be available ($5.00) from the Center for International 
Education and Research in Accounting, 320 Commerce Building 
(West), Box 109, University of Illinois at Urbana-Champaign, Ur- 
bana, Illinois 61801 U.S.A. 




The Pagatoric Theory 
of Financial Income Determination 



Erich Kosiol 



With this work the Center brings to a large part of the international read- 
ing public the first exposition of a unique and important theory of accounts. 
Professor Kosiol, a uniquely gifted individual with long experience in both 
the academic and professional worlds, has throughout his creative lifetime 
perfected his pagatoric theory of financial statements. This monograph 
is his statement of that theory. 

Professor Kosiol had a unique opportunity to study with some of the lead- 
ing accounting theorists during his student years and became particularly 
aware of the two rather diametrically opposed theories of financial state- 
ments and underlying accoundng data. He evolved his own special com- 
prehensive accoundng theory structure. The reader will note that it is a 
thoroughly integrated theory which encompasses the wide variety of eco- 
nomic transacdons which an enterprise may encounter. Professor Kosiol's 
pagatoric theory has been described by leading academicians as a unique 
logically integrated theory system and that it is the best known of such 
complete theory structures. Professor Kosiol's theory specifically includes 
the subjects of income determination as well as the theory of accounts, 
financial structures, and valuations theory. Professor Kosiol's producdve 
life has had as a unique conceptual thread the continuing evoludon and 
perfecdon of the pagatoric concept. 



Copies will be available ($5.00) from the Center for International 
Education and Research in Accoundng, 320 Commerce Building 
(West), Box 109, University of Illinois at Urbana-Champaign, Ur- 
bana, Illinois 61801 U.S.A. 







Accounting for Common Costs 

and 

A Bibliography of Cost Accounting: 
Its Origins and Development to 1914 

M. C. Wells 

The Center for International Education and Research in Accounting has 
as one of its major purposes the publication of scholarly contributions in 
the field of international accounting. With the publication of this compre- 
hensive study by Professor Murray G. Wells, I believe the Center has 
published a seminal work. 

Professor Wells' scholarship is thorough and comprehensive. He has turned 
his efforts to one of the most difficult problems in accounting. His partic- 
ular area of concern is the important one of allocating "common overhead 
cost of products." Professor Wells has completed an exhaustive study of the 
literature in this area. We believe the reader will be given a useful explana- 
tion of the historical background and present discussion of accounting 
practice relating to overhead allocations. 

In addition to the monograph, Professor Wells has also compiled a com- 
prehensive bibliography of this topic. We believe it is the most comprehen- 
sive yet compiled and should serve accounting scholars well in the future. 
The bibliography is published in a companion volume and is an integral 
part of the research. 



Copies will be available from the Center for International Education 
and Research in Accounting, 320 Commerce Building (West), Box 
109, University of Illinois at Urbana-Champaign, Urbana, Illinois 
61801 U.S.A. (Price: $8.00 each or $14.00 per set.) 




The Impact of Inflation on Accounting: 

A Global View 



If one examines the long history of accounting, a focal point for continuing 
theory debate quite clearly has been in the area of valuation. More specif- 
ically, from accounting's very origins, the question of data in the accounts has 
been concerned with the original cost versus some other values. In modern 
times and for varying reasons given by many commentators, the question of 
recording values in the accounts has become more acute. In recognition of 
this growing debate which has a significant international impact, the Center 
planned a seminar with the theme, The Impact of Inflation on Accounting: 
A Global View. 

In 1978 we were in a period of continued extensive debate concerning the im- 
pact of inflation on accounting data. This is not a new discussion but perhaps 
it has become more intense or viewed more seriously than earlier. The many 
cylical economic periods centuries ago in Great Britain and Europe had their 
impact upon accounting. The French company laws, the German balance 
sheet laws, and the English Company Acts are all manifestations of attempts 
to legislate appropriate action where accounting data faces the disorganization 
or stress caused by fluctuating market valuations. It seemed most appropriate 
to take a new perspective in 1978 of the international debate centering on the 
impact of inflation on accounting. We were pleased to have extraordinarily 
capable speakers to talk on this topic. Dr. Sprouse of the Financial Account- 
ing Standards Board typified the type of scholar who gave presentations for a 
seminar of this type. Specific individual presentations in the seminar dealt 
with current concerns and current proposals in the inflation area. 

We do not presume that the debate of whether accounting data should be ad- 
justed or should reflect current market valuations has now been settled. We 
feel the problem is international in its importance and believe the pressures of 
inflation increase the pressure on accounting to attempt to provide a theory 
that will accommodate the specific reporting needs of a period of inflation. 
These pressures seem to vary directly with the rate of inflation. In the inter- 
national area we have had a number of specific cases where countries have 
experienced inflationary rates of such magnitude that the original cost frame- 
work accounting data obviously had to be supplemented or adjusted. 

We also attempted in the Index on Inflation to prepare a comprehensive 
bibliography on the inflation and accounting area of articles written during 
the past five years. We hope it will be useful to provide both specific refer- 
ence to key works and also to indicate the pervasiveness of various themes 
within this overall area of debate. 



Copies will be available ($6.00) from the Center for International 
Education and Research in Accounting, 320 Commerce Building 
(West), Box 109, University of Illinois at Urbana-Champaign, Ur- 
bana, Illinois 61801 U.S.A. 



You could do it 

or go right to the source. 




The 1979 AUBER Bibliography 



FACT: The AUBER Bibliography provides the researcher with 
information that is not found in standard indexes— namely 
monographs and working papers. 

FACT: Over 2,200 working papers, monographs, regional business 
reports, journals, conference reports, books, and technical 
reports produced by member institutions of the Associa- 
tion for University Business and Economic Research 
(AUBER) and the American Assembly of Collegiate 
Schools of Business (AACSB) are listed— 10% more than 
in last year's Bibliography. 

FACT: Information is listed in three different ways to facilitate 
research: by subject, institution, and author. If you miss a 
listing in one section, you'll catch it in another. 

FACT: Over the past 22 years, thousands of researchers, teachers, 
managers, public administrators, students, statisticians, 
librarians, and writers have used the AUBER Bibliography 
to locate the materials they need. 

FACT: At only $12.50, the AUBER Bibliography costs the same 
as it did in 1978. 

FACT: You can order your copy of the AUBER Bibliography, 
Volume XXIII, by sending a check for $12.50 made out 
to AUBER-WVU Bookstore and mailing it to the 

Bureau of Business Research 

209 Armstrong Hall 

West Virginia University 

Morgantown, WV 26506 



ONE YEAR'S SUBSCRIPTION TO THE INTERNATIONAL 
JOURNAL OF ACCOUNTING EDUCA TION AND RESEARCH 

Volumes 1 through 12 (1965-77) $60.00 

Also available $5.00 per volume or 
$3.00 per single-copy issue 

Volumes 13 through 15 (1977-80) 30.00 

Also available $10.00 per volume or 
$5.00 per single-copy issue 

OTHER PUBLICATIONS OF THE CENTER FOR INTERNATIONAL 
EDUCATION AND RESEARCH IN ACCOUNTING 

A Statement of Basic Accounting Postulates and 

Principles (English or Spanish Edition) 1.00 

Theory of Accounts in Double-Entry Bookkeeping, 

by Karl Kafer 3.00 

The Evolution of Direct Costing, by Charles Weber 3.00 

The Nature and Stages of Accounting Dei>elopment 

m Latin America, by Edward Elliott 4.00 

Input-Output Analysis and Its Application to 

Business Accounting, by Shawki Farag 4.00 

The Role of Accounting in the Economic 

Dei'elopment of England 1500-1750, by James O. Winjum 4.00 

Accounting Research 1960-70: A Critical Evaluation, 

Nicholas Dopuch and Lawrence Revsine, editors 5.00 

Cost Terminology and Cost Theory: A Study of Its 
Development and Present State in Central Europe, 
by H. M. Schoenfeld 5.00 

The Pagatoric Theory of Financial Income 

Determination, by Erich Kosiol 5.00 

Accounting for Common Costs, by M. C. Wells 8.00 
A Bibliography of Cost Accounting: Its Origins 

and Development to 1914, by M. C. Wells 8.00 

Available as a set 14.00 

Accounting in the Golden Age of Greece: A Response 

to Socioeconomic Changes, by George J. Costouros 5.00 

WRITTEN CONTRIBUTIONS OF SELECTED 
ACCOUNTING PRACTITIONERS 

Volume 1, by Ralph S. Johns 5.00 

Volume 2, by Paul Grady 8.00 

Volume 3, by Andrew Barr 15.00 

EDITED PAPERS OF INTERNATIONAL 
SEMINARS 

1977 — The Multinational Corporation: 

Accounting and Social Implications 6.00 

1978 — The Impact of Inflation on Accounting: 

A Global View 6.00 

CONTEMPORARY ISSUES IN INTERNATIONAL 
ACCOUNTING: OCCASIONAL PAPERS 

Status of Social Reporting in Selected Countries, 

by Estes, Jaruga, Schoenfeld, et al. 3.00 



TER FOR INTERNATIONAL EDUCATION AND RESEARCH IN ACCOUNTING 



THE LI BR/ 



OCT 



UNIvl^ 
At m 



t:Y Or I i,t 



180 

li LIIMUIS 
p AIGN 




VOLUME 16, NUMBER 1, FALL 1980 

THE 

INTERNATIONAL 

JOURNAL OF 

ACCOUNTING 






EDUCATION AND RESEARCH 



UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN 



CENTER FOR INTERNATIONAL EDUCATION AND RESEARCH 
IN ACCOUNTING OF THE COLLEGE OF COMMERCE 
AND BUSINESS ADMINISTRATION 

The Center for International Education and Research in 
Accounting was established to foster the international devel- 
opment of education and research in the accounting discipline, 
to provide a base for the international exchange of ideas and 
materials relating to accounting education, to encourage and 
assist both accounting faculty personnel and students from 
other countries to come to the University of Illinois at Urbana- 
Champaign for study and research in accounting, and to pro- 
vide faculty members for assignment to universities in other 
countries. 

The center, functionally and administratively, is a constituent 
part of the Department of Accountancy and the College of 
Commerce and Business Administration of the University of 
Illinois at Urbana-Champaign. The graduate training of a sub- 
stantial number of international students has been an impor- 
tant activity of the department for many years. 

One of the specific goals of the center is the publication of 
reports, booklets, and monographs which further the cause of 
advanced education and research in accounting. 

V. K. Zimmerman, Director 




THE 

INTERNATIONAL 

JOURNAL OF 

ACCOUNTING 

EDUCATION AND RESEARCH 



Volume 16 ■ Number 1 ■ Fall 1980 

CENTER FOR INTERNATIONAL EDUCATION AND RESEARCH IN ACCOUNTING 
UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN 

© 1980 by the Board of Trustees of the University of Illinois 



The International Journal of Accounting Education and Re- 
search is published semi-annually, spring and fall, by the 
Center for International Education and Research in Account- 
ing, College of Commerce and Business Administration, Uni- 
versity of Illinois at Urbana-Champaign. Subscription rates 
are $10.00 per year. Single-copy price is $5.00. Copies of prior 
issues are still available. 

Manuscripts and communications for the editor and business 
correspondence should be addressed to The International 
Journal of Accounting Education and Research, 320 Com- 
merce Building (West), University of Illinois at Urbana- 
Champaign, Urbana, Illinois 61801. 

V. K. Zimmerman, Editor 
JaNoel S. Lowe, Assistant Editor 






Contents 



THE INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE — 

RECENT DEVELOPMENTS AND CURRENT PROBLEMS 1 

DONALD J. HAYES 

THE MEASUREMENT OF CORPORATE PROFITABILITY ON A 

CASH-FLOW BASIS 1 1 

G. H. LAWSON 

REGULATION OF FINANCIAL ACCOUNTING: AN INTERNATIONAL 

PERSPECTIVE 47 

DHIA D. ALHASHIM 

A COMPARISON OF VARIOUS INTERNATIONAL PROPOSALS 

ON INFLATION ACCOUNTING: A PRACTITIONER'S VIEW 63 

WILLIAM P. HAUWORTH II 

PRIMARY-SECONDARY REPORTING: A CROSS-CULTURAL ANALYSIS 83 

FREDERICK D. S. CHOI 

ACCOUNTING FOR JOINT VENTURES WITH THE SOVIET BLOC AND CHINA 105 

RONALD E. HOYT and LAWRENCE D. MAPLES 

INTERNATIONAL REPORTING ASPECTS OF SEGMENT DISCLOSURE 125 

JERRY ARNOLD, WILLIAM W. HOLDER, and M. HERSCHEL MANN 

INTERNATIONALIZATION OF THE ACCOUNTING CURRICULUM 137 

STEVEN M MINTZ 

FOREIGN OPERATIONS DISCLOSURES BY U.S.-BASED MULTINATIONAL 
CORPORATIONS: ARE THEY ADEQUATE? 153 

VINOD B. BAVISHI and HAROLD E. WYMAN 

COMPUTERIZED ACCOUNTING: INTERNATIONAL ISSUES 169 

HARTMUT J. WILL 

THE PROBLEMS OF CONSOLIDATION OF ACCOUNTS OF A MULTINATIONAL 

ENTERPRISE: SHELL GROUP OF COMPANIES — SHELL TRANSPORT 

AND TRADING COMPANY, LIMITED, U.K. 209 

ERIC F. CASTLE 

THE PREDICTIVE ABILITY OF FINANCIAL RATIOS USING ALTERNATIVE 

TRANSLATION METHODS FOR FOREIGN-CURRENCY FINANCIAL STATEMENTS: 

A SIMULATION STUDY 221 

YAW M. MENSAH and LOUIS F. BIAGIONI 

AN APPROACH TO "ENVIRONMENTALIZING" MNE PERFORMANCE 

EVALUATION SYSTEMS 247 

HELEN G. MORSICATO and MICHAEL A. DIAMOND 



A Note from the Editor 



As in the case of some earlier issues of the Journal, this issue provides 
the complete record of the proceedings of an international seminar 
on accounting. This seminar, focussing on the current practical and 
theoretical problems in international accounting, was held in Urbana, 
Illinois, on April 10-12, 1980. The edited copies of the papers pre- 
sented at the seminar are included. We are indebted to Ms. JaNoel 
Lowe for her assistance with the technical editing and processing of 
the manuscripts. 

A review of the scope and nature of the seminar papers is revealing. 
Although no startling new theoretical or practical problems are re- 
vealed, significant new areas of emphasis in international accounting 
are evident. The refinement of international accounting practice is 
apparent. The slow but necessary international articulation of ac- 
counting practices and reports is also revealed. Complex environmental 
factors exist when accounting activities cross national political bound- 
aries. These papers recognize the managerial and reporting problems 
that now exist in international accounting. The special legal, social, 
and political characteristics of the multinational corporation are clearly 
present and in need of some logical and coherent accounting responses. 

Accounting for international economic events in the existing inter- 
national structure of relatively inflexible legal regulations presents a 
special problem to the international accountant. The international 
setting continues to change. Thus, the efforts of international accoun- 
tants to achieve a harmonization of accounting theory and practice 
occur in a changing and dynamic setting, and agreements on new 
international standards are transient achievements at best. 

The papers of this seminar provide some new insights of appropriate 
responses to our present international accounting managerial and 
reporting needs. Our common awareness of these problems is increas- 
ing, and we hope that our ability as accountants to respond to a 
dynamic global environment is also increasing. 

V. K. Zimmerman 



The International Accounting Standards 
Committee — Recent Developments 
and Current Problems 

DONALD J. HAYES* 



The International Accounting Standards Committee (IASG) was 
founded seven years ago by the national accountancy bodies of Aus- 
tralia, Canada, France, Germany, Japan, Mexico, the Netherlands, 
the United Kingdom and Ireland, and the United States. Since that 
date, the IASC has issued thirteen accounting standards and has com- 
menced the process for the issuance of a number of others. Its mem- 
bership has increased so that it now represents more than 400,000 
accountants in forty-six countries. Hundreds of those accountants have 
been directly involved in the IASC process through task forces and 
the board itself and thousands of others through the comment letter 
process. By any reasonable measure of success, the IASC efforts to date 
have been highly successful. But the author would be quick to recog- 
nize that success, like beauty, exists primarily in the eye of the be- 
holder and there are other evaluators who might express reservations 
on the appraisal of IASC's success. They might even disagree. 

NEED FOR INTERNATIONAL ACCOUNTING STANDARDS 

In evaluating the work of the IASC, the evaluator must first reach con- 
clusions as to how much can and should be accomplished with regard 

* Donald J. Hayes is a CPA and partner in the Los Angeles office of Arthur 
Young & Co. He is a U.S. representative to the International Accounting 
Standards Committee. 



2 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



to the setting of international accounting standards. The author has 
identified at least three schools of thought on this point. 

In school number 1 are those who believe that international account- 
ing standards represent a critical need that should be fulfilled by the 
establishment of a supreme rule-making body for issuance of uniform 
and inflexible standards to be applied in the identical manner by ac- 
countants throughout the world. In my view, development of such 
standards would require a tremendous expenditure of time and money 
in order to deal effectively and specifically with the great diversity of 
circumstances throughout the world, and even then, they might not 
be accepted. Certainly, IASC, as a part-time committee meeting ten 
to twelve days a year and operating with an annual budget of approx- 
imately $300,000, would have to be substantially reinforced for that 
kind of assignment. To put the IASC budget in perspective, it may be 
noted that the full-time Financial Accounting Standards Board (FASB) 
effort in the United States involves a cost of approximately $6 million 
annually. The author views supporters of this school as politically 
naive. 

In school number 2 are those who believe that circumstances through- 
out the world are too diverse, that therefore useful international ac- 
counting standards of any sort are unachievable and that we should 
not waste our time trying to develop them. Members of this school of 
thought would emphasize the need for additional disclosure in finan- 
cial statements to enable users of the statements to reconcile differences 
between the foreign and local standards as they see fit. The author 
views supporters of this school as defeatists and believes plans for 
reconciling disclosures are unworkable in practice and merely promote 
confusion. 

In school number 3 are those, including the author, who fall between 
the first two schools of thought. This group agrees that the world is 
too complex for us to reasonably expect that rigid, inflexible standards 
can be developed for each issue in the current generation, or for that 
matter, the next. But they believe that worldwide understanding of fi- 
nancial statements would be improved by the elimination of obvious 
bad accounting practices and by the development of certain basic inter- 
national standards to discourage unjustifiable differences in practices. 
This group would accept some flexibility in standards as a necessary 
price of progress and in recognition of the difficulty of accommodating 
the diversity of worldwide circumstances. They would also provide for 
disclosure requirements — but not complete reconciliations — to miti- 



International Accounting Standards Committee 3 



gate the impact of permitting some flexibility. The author views sup- 
porters of this school as realists. 

"Into which school do most IASG members fall?" you may ask. 
While not speaking for the IASC on this matter, the author believes that 
most IASC members adopt the mid-course, or the "realist" point of 
view. They believe that instant uniformity is often not practical and 
that progress in international accounting standard setting must be 
viewed with a long-range perspective rather than with a view toward 
immediate spectacular results. And they believe the present IASC 
effort is quite worthwhile when assessed realistically against a very 
complex worldwide environment. It is against this background that 
this paper discusses some of the problems facing the IASC, how the 
author believes IASC should react to them, and some of its recent 
accomplishments. 

PROBLEMS FACING IASC 

One problem has been recognition and acceptance of IASC standards. 
It has been far less than ideal and therefore a problem. The degree 
to which IASC standards have been incorporated into the national 
standards of the various member bodies of IASC has varied. While 
the member bodies have agreed to use their best endeavors to comply 
with IASC standards or to see to it that there is disclosure of non- 
compliance, success in these endeavors has varied. Early international 
accounting standards covered areas that, while often complex, did 
not have to overcome significant international disagreement on basic 
measurement principles. For example, International Accounting Stan- 
dard (IAS) No. 1 called for enterprises to disclose their accounting 
policies. However, recent international accounting standards cover 
more controversial areas, and the IASC has found it increasingly diffi- 
cult to achieve agreement on a single basic principle. As a result, it 
has allowed limited alternative accounting methods for the same trans- 
action supplemented by a requirement for disclosure of the relevant 
facts including the method used. While this flexibility has facilitated 
adoption of the standards on an international basis, it has also caused 
some observers to question whether the IASC is properly fulfilling its 
role. But there are a number of underlying circumstances that must 
be considered in assessing how to resolve this problem. 

First is that it is difficult for the IASC to synchronize its efforts 
with those of individual member countries. Different countries have 
different priorities with regard to the issues involving accounting 



4 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



standards that they believe need to be resolved, with the result that 
while one country gives top priority to one issue, another gives it to a 
different one. As a result, the IASC often finds itself dealing with 
issues that one country has resolved just recently but about which 
another has not yet initiated a study. In these circumstances, it can 
be expected that the implementation of particular IASC standards in 
various countries will require a period of time before the local ac- 
counting standard-setting body has the opportunity to initiate an 
effort to implement a comparable local standard. Acceptance can not 
be expected to occur overnight. 

A second circumstance that must also be recognized is that the 
IASC will not necessarily be dealing with particular standards in the 
same depth as the accounting standard-setting bodies of certain ad- 
vanced countries. This is because of the IASC's desire to keep the 
standards relatively simple and understandable throughout the world. 
But at the same time, the accounting professions in developing coun- 
tries are still in the early stages of setting accounting standards on 
basic matters, and they are years away from dealing with complex 
subjects such as lease accounting or inflation accounting that are now 
before the IASC. In summary, the IASC cannot lead the way for the 
most advanced professions without creating acceptance complications 
for the less advanced professions. 

A third circumstance affecting acceptance relates to the fact that 
the IASC is comprised only of professional accountancy bodies and 
the board of the IASC, which issues the standards, is comprised pri- 
marily of the accountancy organizations from developed countries. 
This situation exists, quite simply, because the accountancy bodies 
were the first to recognize the need for standards and to take some 
constructive action and because the professions from the developed 
industrialized countries had the most experience and resources to con- 
tribute to the process. There certainly has been no plan on the part 
of the IASC to exclude any parties or countries from the process who 
have a legitimate interest in international accounting standards and 
are willing to contribute to the process. But it would be almost impos- 
sible for IASC to function if it were expanded to include representa- 
tives from every country and faction. 

With all of these complicated circumstances, it is quite unrealistic 
to expect that the separate national accounting standard-setting bodies 
throughout the world will be marching in perfect cadence with IASC 
standards. Recognition and acceptance must be assessed in realistic 
terms, and it will take time. 



International Accounting Standards Committee 5 



A second problem has been asserted to be a lack of identification of 
objectives of financial statements, or the broad theoretical underpin- 
nings of accounting. Some critics view the IASC failure to identify and 
define the worldwide objectives of financial statements as a major 
failing that impedes progress. Who are financial statements intended 
to serve? In the United States, the investor and creditor are viewed 
as the primary audience for financial statements. Other countries give 
significant weight to the needs of labor unions, employees, government 
planners, and taxing authorities. Some countries, particularly develop- 
ing countries, perceive the need for economic data for macroeconomic 
planning and social purposes as a major factor that should influence 
the thrust of accounting standards. Generally speaking, the IASC 
has been attempting to harmonize existing national standards — which 
presumably have been developed with some objectives in mind — 
rather than to develop totally new standards as if starting from a clean 
slate. So at this stage, failure to more specifically identify objectives of 
financial statements has not been a major obstacle to progress. Never- 
theless, there is no doubt that perceptions of different objectives of 
financial statements by different countries have forced the IASC to 
accept some flexibility in its standards that might not be required if 
objectives were better defined. 

A third problem has been intervention by international govern- 
mental bodies. It is complicating an already complicated situation. 
One such body is the United Nations. A few years ago, the UN com- 
missioned a study which led to a much-discussed report, "International 
Standards of Accounting and Reporting for Transnational Corpora- 
tions." The report advocated that extensive disclosures be made by 
both multinational and national companies, involving not only finan- 
cial accounting areas, but also "social matters" — for example, a de- 
scription of the enterprise's labor relations policy and a description of 
completed environmental protection measures. Critics of the report 
expressed concern that perhaps only multinationals would be required 
to comply with these extensive disclosures, and if so, the multinationals 
would be put at a competitive disadvantage relative to national com- 
panies. Critics also said there was not a country in the world that 
requires all of the recommended disclosures, and the cost of reporting 
the information would exceed benefits to be derived from it. 

In response, the UN has established a new group to review the 
first report and to prepare a new one. At the group's first meeting last 
February, Klaus Sahlgren, executive director of the UN Centre on 



6 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Transnational Corporations, reiterated that "the United Nations is 
committed to the long-term objective of establishing an international 
comparable system of standardized accounting and reporting." The 
membership of this new group consists of representatives from thirty- 
four countries: nine from Africa, seven from Asia, six from Latin 
America, three from eastern Europe, and nine from western Europe 
and "other states." It is interesting to note that the two countries with 
the most extensive accounting disclosure in the world — Canada and 
the United States — are included in "other states." The new group has 
agreed to consult with the IASC but may not adopt the IASC standards 
as a framework for their own recommendations. Underlying the UN's 
interest in accounting and reporting standards is its comprehensive in- 
formation system, which, while in the initial phase at the moment, 
will include a detailed, computerized financial data bank on multi- 
national companies. 

IASC representatives, including the author, attended the most re- 
cent meeting of the new group, and the IASC expects to have a con- 
tinuing liaison with it. A central thrust of the UN efforts is to help 
developing countries, particularly in their dealings with transnational 
corporations. Improving disclosures of segmented results, related party 
transactions, and socially significant information have been emphasized. 
But no definitive standards have yet resulted from this effort. 

Another governmental body involved is the Organization of Eco- 
nomic Cooperation and Development (OECD). In 1976, the OECD 
issued "Guidelines for Multinational Enterprises," calling for, among 
other things, the voluntary disclosure by multinationals of their operat- 
ing results and sales by geographical area, and the policies they use 
relative to intragroup pricing. These guidelines have been publicly 
supported by the United States government and by the International 
Chamber of Commerce. At least one country, Australia, has indicated 
that it desires foreign companies operating in Australia to observe the 
guidelines, and it uses them as a point of reference when viewing 
applications by foreign companies for investments in Australia. Trade 
unions in Europe have also cited the OECD guidelines in disputes with 
management. 

To assess how compliance with the voluntary guidelines was pro- 
ceeding and to review international accounting matters in general, 
in early 1979 the OECD established an ad hoc working group on ac- 
counting standards. In its recently completed report, the group re- 
ported that it had found certain weaknesses in the guidelines — speci- 



International Accounting Standards Committee 7 



fically, in the lack of standards for measuring the items to be disclosed. 
For example, the guidelines call for disclosure of research and de- 
velopment expenditures, yet they do not define "research and develop- 
ment." The group stated that without measurement standards, there 
cannot be international uniformity of reporting. The report took note 
of the work of the IASG but stated that the IASC, being a private, 
narrowly constituted body, could not be asked to prepare the measure- 
ment standards to support the OECD guidelines. The OECD also has 
failed to produce a single definitive accounting standard. 

Finally, the European Economic Community (EEC) is also sub- 
stantially involved in accounting standards setting. On July 24, 1978, 
the EEC published its Fourth Directive on Company Law, which will 
generally be effective in 1981 (each member country has some lati- 
tude in determining an effective date). This directive deals with the 
annual preparation of financial statements by corporations operating 
in EEC member countries. Its purpose is to harmonize the content 
and presentation of financial statements issued by these corporations. 
It also requires conformity of certain principles of accounting, such 
as those dealing with goodwill, research and development, and invest- 
ments. The directive calls for all enterprises subject to its require- 
ments to prepare their balance-sheet and income statements in ac- 
cordance with the very specific format described in the directive. Both 
the financial statement presentation and accounting principles require- 
ments differ in certain respects from practice in many other countries 
in the world, including Canada and the United States. 

The EEC has also issued for discussion a draft of a seventh direc- 
tive covering consolidated financial statements. This directive would 
require enterprises operating in the EEC but headquartered elsewhere 
to prepare financial statements which consolidate all of their subsidi- 
aries located in or controlled from EEC countries. The accounting 
policies used to prepare these financial statements would have to be 
consistent for each company in the consolidation, and furthermore 
would have to be generally accepted in one of the countries involved. 
For example, a U.S. multinational with subsidiaries in Belgium, Eng- 
land, and France would be required to publish combined financial 
statements for these subsidiaries using principles of accounting generally 
accepted in either Belgium, England, or France. If the three subsidi- 
aries had controlling investments in companies outside the EEC, these 
would have to be included, presumably on either the consolidation or 
equity basis, depending upon the degree of control. 



8 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



These directives, and others to come, will likely have a major im- 
pact on multinational companies with significant operations in the 
EEC member countries. The IASG has been generally able to accom- 
modate to the EEC standards, but this may not always be the case. 

HOW IASC SHOULD REACT 

As a result of these three problems, the author believes that the IASC 
must take a number of steps : 

1. It must broaden its organization to provide for greater involvement 
in its activities by auditors, preparers, and users of financial statements 
in all sections of the world. 

2. It must increase its efforts to enlist the support of other organiza- 
tions interested in accounting standards such as the UN, EEC, OECD, 
stock exchanges, and business organizations in order to gain greater 
acceptance of its pronouncements. 

3. It must further investigate the reasons for nonacceptance of its stan- 
dards and initiate education and other types of programs to gain ac- 
ceptance. 

4. It must promote discussions among major national accounting 
standard-setting bodies to deter major countries from going in differ- 
ent directions on such subjects as deferred taxes, foreign-currency 
translation, and inflation accounting. 

5. It must undertake preliminary work to explore objectives of finan- 
cial statements from a worldwide viewpoint so that a better founda- 
tion is established for a second-phase effort to further narrow alterna- 
tive accounting methods. 

ACCOUNTING ISSUES FACING IASC 

The author is pleased to report that the IASC is actively pursuing 
most of these matters. At the same time, it is also dealing with a heavy 
agenda of accounting issues including proposed standards on the 
following subjects: 

1. Supplementary disclosures of the effects of changing prices. This 
proposed standard provides for supplemental disclosure of income in- 
formation adjusted to reflect the impact of either general price-level 
changes or specific price-level changes. 

2. Accounting for property, plant, and equipment. This proposed 
standard would, among other things, define the circumstances under 
which expenditures relating to plant and equipment should be capital- 
ized. 



International Accounting Standards Committee 9 



3. Accounting standards on revenue recognition. This proposed stan- 
dard would define the conditions that should be met in order for 
revenue to be recognized. It would include an appendix illustrating 
how the standard would apply to a variety of types of transactions. 

4. Accounting standards on accounting for government grants. This 
proposed standard would specify the accounting for government grants, 
with particular emphasis on the basis for reflecting such grants in 
income. 

5. Disclosures in financial statements of banks. This is a discussion 
paper intended to solicit views on some recommended bank disclosures, 
most of which are consistent with those presently required by the 
Securities and Exchange Commission in the United States. 

6. Accounting for retirement benefits in the financial statements of 
employers. This proposed standard calls for the current accrual of 
retirement benefits. Such accruals would be based on accepted actuarial 
methods and would include provision for amortization of past service 
cost over the service lives of active employees. 

7. Reporting of financial information by segment. This proposed 
standard provides for disclosure of income information by industry 
group and geographic areas. 

8. Accounting for business combinations. This subject is in the early 
stages of discussion. The IASC will attempt to specify the circumstances 
under which purchase accounting, pooling of interests accounting, and 
new entity accounting would apply and the related requirements to 
implement each method. 

9. Accounting for interest costs. This subject is in the early stages of 
discussion. The IASC will attempt to specify the circumstances, if any, 
under which interest should be capitalized. 

10. Accounting for leases. This proposed standard provides for the 
capitalization of finance leases by both lessees and lessors. It is similar 
in most respects to FASB Standard No. 13. 

11. Accounting for foreign-currency translation. Work on this proposed 
standard was suspended pending resolution of the current review of 
FASB Standard No. 8 in the United States. Should the U.S. standard 
move in the direction that was recently announced by the FASB, de- 
velopment of an international standard on a basis that will harmonize 
practice should be attainable. 

FUTURE PROSPECTS 

When the IASC has completed these topics, it will have covered most 



10 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



of the areas of accounting dealt with in professional literature in the 
United States. However, this author does not visualize that reaching 
that point will be the end of the IASC process but rather only the end 
of the beginning. A sound foundation will have been established for a 
second-phase effort to continue to narrow alternative practices. 

This year and the next will be a challenging period for IASC. It 
will need the continued support of accountants in public practice, in 
industry, and in academe if it is to be successful in this period and 
in the long run. The views of academicians will be particularly wel- 
come. As one philosopher stated, "To be receptive to criticism means 
to erase half of every deficiency and fault." IASC does not claim to 
be free from fault. It is responding to changing times and circum- 
stances to maintain its leadership role. With help and suggestions 
from all parties interested in international accounting issues, IASC 
should be able to meet the new challenges just described. Indeed, it 
must if international accounting standards are to continue moving 
forward. 



The Measurement of Corporate Profitability 
on a Cash-flow Basis 

G. H. LAWSON* 



INTRODUCTION 

This paper has theoretical, analytical, and empirical content. The 
theory and analysis are largely to be found in the first five sections 
while the empiricism is reported in the remaining three. 

The theory and analysis outlined here attempt to specify a compre- 
hensive multiperiod accounting model which integrates financial per- 
formance from a corporate perspective with performance from a stock- 
holder or stock market standpoint. It seems reasonable to suppose that 
there should be a consistency between performance in these two senses ; 
indeed, in the author's opinion, the one is the mirror image of the 
other. The analysis also includes the derivation of cash-flow statements 
from published accounting data and therefore describes the manner in 
which the aggregate and individual company cash flows reported here 
were ascertained. 

One of the most fundamental aims of the analysis is the derivation 
of a rigorous method of ascertaining effective rates of tax on the cor- 
porate sector or effective rates of tax on corporate investment, which 
amounts to the same thing. The effective rates reported here suggest 

* G. H. Lawson is professor of business finance and director of the doctoral 
programme, Manchester Business School, University of Manchester, United 
Kingdom. 

Financial support from the Social Science Research Council, the Esm6e Fair- 
bairn Charitable Trust and the Association of Certified Accountants for the 
research reported in this paper is gratefully acknowledged. The author is also 
grateful to Keith Thompson and Kian Chin for their contributions to the 
empirical analysis. 



12 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



that post-war U.K. fiscal policy has been a very severe deterrent to 
corporate investment. 

A further important conclusion which emerges from the empiricism 
is that, in basing dividend policies on historic cost profits, U.K. com- 
panies have generally paid uncovered dividends, thus substituting debt 
for equity which, in turn, has contributed to a decline in equity market 
values. 

A compelling aspect of cash-flow accounting, which also emerges 
in this paper, concerns the extent to which cash-flow results deviate 
from those yielded by other accounting models. By and large, cash- 
flow variables take on much lower values than their historic cost, cur- 
rent cost accounting (CCA), and replacement counterparts. The in- 
terpretation of cash-flow performance must therefore be seen as an 
integral part of both ex post and ex ante performance measurement. 

CASH-FLOW STATEMENTS EXPRESSED IN MONEY TERMS 

A total cash-flow statement for any year j can be expressed as: 

(k,-hj) ±B j ±N j ±M j ^(A j + R j -Y j ) +F,+tj (1) 

+ D, ± H, 

that is, 

total cash inflows = total cash outflows (including liquidity change) 

where, in year j, 

kj — hj stands for operating cash flow, that is, cash, k j5 col- 

lected from customers minus cash, hj, paid to suppliers 
of all goods and services other than capital goods; 

Bj is new capital received ( + ) from equity shareholders 

or repaid ( — ) thereto; 

Nj is new medium- or long-term loans raised ( + ) or re- 

paid ( — ); 

Mj is the increase ( + ) or decrease ( — ) in bank over- 

drafts and/or short-term loans; 

Aj + Rj — Yj represents net cash outlays on capital investment com- 
prising replacements, Aj, growth investment, Rj, and 
displacements, Yj ; 

Fj represents interest payments; 

tj is the corporate tax payment; 

Dj is the dividend paid to shareholders; and, 

Hj represents the increase ( + ) or decrease ( — ) in liquid- 

ity. 



Corporate Profitability Measurement 13 



Any cash-flow concept of periodic earnings must evidently be wholly, 
or partially, represented by some variant of the basic cash-flow identity 
represented by ( 1 ) . For example, 

(k,-h,) - (A, + R,.-Y,) -t4TH, — (F,TN,=PM,) (2) 

+ (D,=FB,) 
that is, 

operating net tax liquidity 

cash — capital — payments + change s= 

flow investment 

lenders' shareholders' 
cash + cash 
flows flows 

or, 

periodic post-tax entity earnings 1 adjusted , ,. „ 

, .,......, = total distributions. 

lor periodic liquidity change 

Alternatively, and by analogy with the equity basis of accounting, 

(k, - h,) - (A, + R, - Y,) - F, - t, a (D, =F B,) =F N, (3) 

+Mj ± Hj 
that is, 

periodic post-tax equity periodic equity cash flows plus debt 

(cash-flow) earnings financing and periodic liquidity change. 

However, if, reflecting transactions and precautionary motives, liquidity 
levels (and therefore periodic liquidity changes, hP Hj) are an active 
decision variable, post-tax periodic equity cash-flow earnings are de- 
fined by the left-hand side (LHS) of the identity 

(kj - hj) - (Aj + R, - Y,) - F, - t, =F H, mm (Dj =? B,) =P (N, 

=PMj) (4) 

that is, 

periodic post-tax equity earnings periodic _ periodic 

adjusted for periodic liquidity change — shareholder + external debt 

cash flows transactions. 

If periodic shareholder cash flows, Dj h= B js exceed the LHS of (4), 
shareholder cash flows may be financed with externally raised debt. 

1 Periodic pretax entity earnings can obviously take on positive or negative values 
depending upon the sizes (and signs) of the operating cash flow, kj + hj, and 
net investment, Aj + Rj — Yj. 



14 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Should there be real debt-equity substitution 2 every year, share prices 
will sooner or later go into a state of long-term real decline. Obvious 
though the logic of this statement is, its implications generally seem, 
for reasons explained below, 3 to have escaped U.K. company director- 
ates throughout the last two or three decades. 

For completeness, periodic equity cash flows, Dj + Bj, that is, divi- 
dends minus (or plus) equity capital raised (or repaid) may be de- 
fined as: 

Dj+B jS (k, - h,) - (Aj + R, - Y,) - F, - t, =F Hj ± N, 

±M,. (5) 

Identity (5) clarifies the structure of the expectations that are alleg- 
edly formed by investors in the determination of share prices. That is 
to say, in attempting to quantify their future equity cash-flow stream, 
investors estimate each of the ex ante determinants shown on the right- 
hand side (RHS) of (5). 

It may also be hypothesized that in forming expectations about a 
company's ex ante cash flows, the market will uncover a company's 
past and current underlying cash-flow generating capacity and utilize 
such ex post data accordingly. 

DERIVATION OF CASH-FLOW STATEMENTS FROM U.K. PUBLISHED ACCOUNTS 

The historic cost measure of (published) periodic profit, HCPj, is given 
by: 

HCP^d,- (aj-x + bj-a,) - L, - F, + (Y,-X,) (6) 
-t j+ i-tj* 

dj stands for accrued sales ; 

aj_! + bj — aj represents the cost of sales, that is, opening inventory, 
aj- 1? plus total accrued revenue expenditure, bj, (other 
than interest) minus closing inventory, a j? which, like 
the opening inventory, is measured on a FIFO basis; 

Lj is total depreciation based on historic cost; 

Fj is accrued interest (for simplicity, interest paid and 

accrued are assumed to be synonymous) ; 

Yj — Xj represents the proceeds, Yj, of assets displaced minus 

the written down book value, Xj, thereof; 

tj +1 is the current year's tax charge which, in the United 

Kingdom, is paid roughly one year in arrears; and, 



1 See p. 15 and following. 
8 See p. 15 and following. 



Corporate Profitability Measurement 15 



tj* is a transfer to a tax equalization (or deferred taxa- 

tion) account. 

Deducting the LHS of (3) from the RHS of (6) yields the difference 
between periodic post-tax equity (cash-flow) earnings and post-tax 
historic cost profit, namely, 

(6) - (3) w* (dj - k,) + (a, - aj-0 - (bj - hj) (7) 

+ (A, + R, - L, - X,) - (t j+1 + tj * - t,) 

that is, 

periodic periodic periodic periodic periodic 

= change in + change in — change in + depreciation + change in 
receivables inventory payables shortfall current and 

values deferred 

tax 

liabilities 
or, 

— Pj +(A j + R j -(t j+1 + tj * 

-L,-X,) -tj) 
that is, 

= periodic working + periodic periodic 

capital investment* depreciation change in 

shortfall 5 taxes 

payable 

A comparison of beginning and end-period balance sheets reveals 
each of the constituents of periodic working capital, pj, the periodic 
change, t j+1 + tj* — tj, in current and deferred tax liabilities, the 
financing transactions, ± Bj ± Nj ± Mj, and the liquidity change, Hj. 
Net periodic investment, Aj + Rj — Y j} can also be directly deduced 
from U.K. published accounts. Hence, the conversion of historic cost 
profit (before depreciation, interest, and taxes), namely, dj — (a-j-i 
+ bj — aj), to operating cash flow, kj — hj, and the derivation of the 
other items needed to complete a periodic total cash-flow statement, is 
purely a matter of arithmetic. Thus, 

* In general, it can be said that, given the periods of trade credit allowed and 
received and the rate of profit, periodic working capital will be higher the higher 
are the periodic increases in sales volume, output, physical inventories, selling 
prices, and costs. See G. H. Lawson and A. W. Stark, "The Concept of Profit 
for Fund Raising," Accounting and Business Research ( 1975) . 
5 An historic cost periodic shortfall will generally be greater the higher the 
amount of growth investment, Rj, the faster the (money) rate of increase in the 
prices of assets acquired and the longer the period over which assets are de- 
preciated. 



16 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



dj - (aj-x + b, — a 4 ) - pj •= k, — hj. (8) 

The tax provision, t j+ i + tj*, is converted into the year j tax pay- 
ment, tj, in like manner. That is to say, 

tax tax change in current and 

paid provided deferred tax liabilities 

tj = (tm + t;*) - (t j+1 + tj *- tj ). 

In short, identities (1), (2), (3), (4), and (5), and their constitu- 
ent parts, are readily derived from published accounting statements. 
Thus, to the extent that conventional accounting data are known or 
inferable, so too are their cash-flow adjuncts. 

CASH-FLOW STATEMENTS EXPRESSED AT A BASE-YEAR PRICE LEVEL 

In any period j, each of the cash-flow identities illustrated above is 
expressed in terms of period j purchasing power. However, since the 
purchasing power of money changes over time, the cash-flow identities 
of period j are not directly comparable with those of periods j + 1, 
j + 2, . . . . To facilitate an interperiod comparison, a sequence of cash- 
flow statements expressed in money terms must be re-expressed at a 
base-year price level by resorting to indices measuring the change in 
the value of money. 

Let the levels of the index measuring the general level of prices be 
Ii, I 2 , . . . . , I n , on the average due dates of years 1, 2, . . . . , n. Thus, to 
re-express the cash-flow identities of year 1 at midyear n prices, they 
are multiplied by I n /Ii- Similarly, to express the cash-flow identities of 
years 2, 3, . . . . , n — 1, in terms of midyear n prices, the respective an- 
nual identities are multiplied by In/l2,In/l3, ■ . ■ • , I n /I n -i- 

Proceeding from the proposition that periodic cash-flow statements 
constitute a summary of financial transactions, all of which are ex- 
pressed in the same purchasing power, conceptually speaking, a peri- 
odic cash-flow statement automatically achieves the adjustments to 
historic cost income statements that result in current cost income 
measures. Hence, in that a sequence of cash-flow statements expressed 
at a base-year price level copes both with relative price changes and 
changes in the value of money, those statements satisfy most, though 
not all, of the desiderata of a rigorous multiperiod inflation accounting 
model. The interpretations afforded by such a model constitute the 
substance of this paper. However, to complete the model's specifica- 



Corporate Profitability Measurement 17 



tion, four further technicalities must be taken into account. These are 
the (cash-flow accounting) treatment of : 

1. The unexhausted benefits of capital expenditure alias the capital 
stock valuation problem ; 

2. The impact of inflation on the real cost of debt; 

3. The calculation of effective tax rates; and 

4. The computation of effective interest cover. 

THE UNEXHAUSTED BENEFITS OF CAPITAL EXPENDITURE 

The treatment of capital expenditure in cash-flow accounting, namely 
its inclusion as a cost in the period in which it is incurred, cannot be 
too strongly emphasized. [See identities (2), (3) and (4).] While con- 
ceding that this treatment gives full effect to asset acquisition costs in 
terms of the purchasing power of the period in which such costs are 
incurred, accountants usually reject "immediate write-off" on the 
grounds that it ignores the unexpired benefits of capital outlays. But 
their own prescription — allocating capital expenditure over the suc- 
cession of periods which enjoys its use — is wholly objectionable. Such 
allocations are inevitably arbitrary and result in asset written down 
values (representing the unexpired benefits) which are equally arbi- 
trary. Written down values do not represent observable real world 
values and are in no way relevant to the returns which can be enjoyed 
by the shareholders and other financiers of a going concern. 

The genuine unexpired benefits of maintaining an asset in use can 
never be more than expectations. Expectations do, however, have a 
value and will be impounded in the market value of a company's 
shares and/or its other financial instruments accordingly. Hence, capi- 
tal expenditure should be treated as a cost in the period in which it 
is incurred and, at the end of the sequence of periods, the (multi- 
period) performance of which is to be measured, the market value of 
a company's shares and loans should in effect be entered as a credit. 
Similarly, the market value of shares and loans should be entered on 
the debit side at the beginning of the sequence since, whatever hap- 
pens thereafter, those values represent the cost of acquiring total 
ownership at the outset. 6 Using these "entry" and "exit" market prices 

6 As a little reflection will suggest, this is the only method which can give exact 
effect to the serial dependence between total investment and subsequent years' 
operating cash flows in the measurement of multiperiod ex post financial per- 
formance. 



18 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



in conjunction with identity (4), the respective n-period ex post 
returns to shareholders, lenders, and to an entity as a whole, can be 
expressed in terms of the familiar internal rates of return defined by 
equations (9), (10), and (ll). 7 

n D • ■+- E V (e) 

n F< ± Ni ± M V (d) 

v < d > = y -^ — m — -^- h — (\o) 

A (l+r d )^ + (l+r d )°- (1Uj 

V (•) 4- V w = V (D^B,) + (F i ±N i ±M i ) V a <°> 4- V n < d > 
° ,ti (l + j (14-r) n 



= 2 

i = - 

4- 



(kj-h,) -(Aj + Rj-Y,) -tj^H, 



jti (l+r)i 

Vn (6) + Vn (d) 

(1+r)- (11) 



where, 



V (e) , V (d) and V n (e) , V n (d) represent the end-year o and 
end-year n market values of a company's equity and debt, 
respectively; and r e , r d and r are the respective equity, debt, 
and entity rates of return over the n-year period in question. 

Although equations (9) and (10) are universally accepted methods 
of denning the returns that are enjoyed by shareholders and lenders 
respectively, their lack of affinity with the historic cost, and indeed 
most other accounting models, is not as widely appreciated. In elabo- 
rating this contention, the following propositions are apposite: 

1. The ex post equity rate of return computation utilizes the stream 
of dividends (adjusted for capital contributions and repayments) and 
not a sequence of periodic equity cash-flow earnings defined by the 
LHS of equation (3). 8 Similarly, given the entry and exit prices of 
debt, the debt flows, Fj ± Nj ± Mj, constitute the basis of the ex post 
debt interest rate. 



1 The incorporation of entry and exit market prices into measures of multiperiod 
performance expressed in absolute terms is discussed in G. H. Lawson, "Com- 
pany Profitability and the U.K. Stock Market — An Exercise in Cash Flow 
Accounting," Research Report (Manchester Business School, March 1979). 
8 A situation such that shareholder cash flows, Dj Zf: Bj, are always equal to 
periodic equity cash-flow earnings as defined by the LHS of (4) can be re- 
garded as an exceptional case. In particular, it requires Nj 4" Mj always to take 
on a value of zero in which event interest, Fj, can only be positive if the com- 
pany originally raised irredeemable debt. Alternatively, periodic equity cash-flow 
earnings will be equal to periodic cash flows only so long as a company is wholly 
equity financed. 



Corporate Profitability Measurement 19 



2. The ex post entity rate of return, r, is by definition the weighted 
average of the debt and equity rates of return. However, unlike the 
equity and debt rate of return calculations, the numerators of the 
successive terms of equation (11) (excluding entry and exit values) 
simultaneously represent periodic entity cash-flow earnings and peri- 
odic proprietorship consumption (and/or external reinvestment by 
the collective entity proprietorship itself) . 

From an economic standpoint, it therefore seems reasonable to con- 
tend that performance should be measured at the entity level and 
that deviations between equity earnings and equity cash flows merely 
reflect variations in the division of periodic entity cash-flow earnings 
as between lenders and shareholders. This reasoning is symmetrical in 
that it clearly does not preclude situations in which negative entity 
cash-flow earnings [LHS of (2)] are financed by further capital from 
both lenders and shareholders. 

Returning more specifically to the unexhausted benefits of capital 
expenditure: the LHS of (4) provides the clearest indication of the 
reason the unexpired benefits of capital expenditure in any individual 
year simply cannot be neglected. Thus, the magnitude of net capital 
expenditure, Aj 4- Rj — Yj, may, for perfectly good reasons, swamp 
the operating cash flow, kj — hj, not to mention the likely additional 
outlays in respect of interest, taxes, and liquidity. If investment deci- 
sions are economically well based, their present values will sooner or 
later be reflected in share values. (In fact, the latter offer the only 
direct means of shareholder access to the unexhausted benefits of cap- 
ital expenditure incurred by a going concern.) Hence, to the extent 
that entity cash-flow earnings are depressed in an individual year be- 
cause of heavy capital expenditure, the company's total market value 
should generally embody a countervailing offset. This offset is in 
theory equal to the actual (end-year) total market value of the com- 
pany minus the total market value that would have emerged had some 
part of Aj + Rj — Yj been distributed as dividends. 9 In other words, 
the analysis of a company's periodic cash flows and the tracking of 
its total market value are integral components of the overall process 
of ex post financial performance appraisal. 

9 By the same token, it can be argued that periodic increases in liquidity which 
smack of excessive caution will depress periodic entity cash-flow earnings but 
simultaneously raise a company's total market value above that which would 
have emerged at some lower level of liquidity. Likewise, heavy payments, hj, to 
suppliers in respect of inventory investment will depress periodic operating cash 
flow but enhance stock market values. 



20 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



One should, of course, countenance the possibility that capital, in- 
ventory, and liquidity investments are neither promptly nor fully im- 
pounded in share prices in the manner postulated above. But that in 
no way negates the contention that periodic entity performance is 
measured by two indices, namely, periodic entity cash-flow earnings 
and market value performance. If market performance is not per- 
ceived to be commensurate with internal investment policies, investors 
can draw the appropriate conclusion. One of the pre-eminent modern 
functions of accounting is the disclosure of information which will 
help investors to sharpen their perceptions in this respect. 

THE IMPACT OF INFLATION ON THE REAL COST OF DEBT 

If financial performance is measured on an entity basis, the real cost 
of debt is irrelevant. In measuring the division of entity (cash-flow) 
earnings between shareholders, the real cost of debt is a pertinent 
question. 10 

Contrary to widespread supposition, it is not axiomatic that inflation 
always provides shareholders with gains at the expense of lenders. Such 
"money gains" actually realized in the form of consumable shareholder 
income stem from a failure by lenders to anticipate fully future infla- 
tion when subscribing for new debt issues. This failure results in a 
sequence of contractually defined interest receipts (specified in money 
terms) which do not fully compensate for the totality of market risk 
and inflation actually borne. But the resultant money gains (if any) 
to shareholders from debt financing are automatically captured by a 
conjunction of the income statement and closing share price. 

Any ex post periodic benefit to shareholders attributable to debt 
financing can only be reflected in an actual interest payment which 
is lower than the interest that would have been paid had the actual 
interest rate been inflation indexed. On the other hand, at the end of 
an accounting period, any shareholder benefits ascribable to outstand- 
ing debt are no more than expectations. But if, like the benefits of un- 
expired capital expenditure, such expectations have a value, they will 
be impounded in the market price of a company's equity shares. 11 

10 It has also emerged as a major unresolved problem in recent U.K. develop- 
ments in current cost accounting. 

u Such unexpired benefits of outstanding debt as are impounded in quoted 
equity prices may alternatively be regarded as the capitalized value of an in- 
cremental sequence of future interest payments that represents the difference 
between future interest payable and that which would be paid were lenders able 
accurately to embody future inflation in interest rates. These benefits can ob- 
viously take on either positive or negative values. 



Corporate Profitability Meausrement 21 



Based on this reasoning, the unexpired benefits of outstanding debt 
represent unexpired losses from a lender's standpoint and, in efficient 
markets, may be assumed to be impounded to an equal and opposite 
extent in the market value of debt. For completeness, it may be added 
that revisions to anticipations of future inflation may be expected to 
trigger equal and opposite adjustments in the market values of debt 
and equity. 

If efficient market assumptions do not hold, it cannot be assumed 
that the unexpired benefits (losses) of debt financing are fully im- 
pounded in the respective market values of debt and equity. If not, 
any shareholder benefits attributable to debt financing can only be 
enjoyed from period to period as interest is actually paid. In these 
circumstances, the unexpired benefits can never be realized by means 
of market transactions by shareholders, can never be enjoyed in ad- 
vance, and should therefore never be recorded in any equity account- 
ing model. 12 This also seems to imply that all equity accounting models 
should in some way utilize the entry and exit prices of equity for the 
computation of unexpired money gains (or losses). 13 But since share 
price appreciation cannot be delivered directly to shareholders by a 
company, there is no sense in which unexpired money gains can be 
regarded as an element of distributable equity income and on this 
criterion they should be entirely excluded from the ex post corporate 
income statements. But this by no means implies that a company 
should not disclose a time-series of (real) market values of debt and 
equity as an adjunct thereto. 

EFFECTIVE RATES OF TAX ON CASH-FLOW EARNINGS 

In calculating the effective rate of tax on a cash-flow basis, entity 
or equity concepts of periodic income can be adopted. However, as 
may be inferred from principles of tax neutrality, the paramount in- 
tention ought to be an assessment of the average tax burden on sus- 
tainable (that is, multiperiod) entity cash flows. Put another way, an 
accurate measure of taxable capacity ought to reflect an undertaking's 
ability to generate cash from economic activity irrespective of its finan- 
cial structure. Be this as it may, both concepts of taxable capacity are 
adopted here. 

12 The ability of a cash-flow approach incorporating stock market entry and exit 
prices automatically to cope with this situation can be counted as a further 
merit of that system. 

13 It is arguable that, for certain periods at least, the market is just as likely to 
overestimate future inflation, in which case shareholders will suffer money losses. 



22 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



It follows directly from equations (9), (10), and (11) — which al- 
low for the unexpired benefits of capital expenditure, liquidity, and 
inventories — that the effective (multiperiod) ex post rates of tax on 
entity and equity cash flow are defined by T and T € in equations (13) 
and (14) respectively, 

V w + V w - * [(k—hi) -(A.+Rj-Yj) ^HjHI-T) 
^ Vo ~~,ti (l+r) j 

V' 9 ' + Vn (<1) 

+ (1 + rT- (13) 

V c.) c= V [(kj ~ hj) ~ (Aj + Rj - Y 3 ) - F, ^ H, ± N, 

±M i ](l-T e ) V n <«> 

(l+r e ) n ^ ; 



The entry and exit values, V (e) and V n (e) , can be regarded as "net 
of tax" market values since they represent the (observable) present 
value of a taxed expected equity cash-flow stream at end-years o and 
n respectively. 14 

Equation (13) can be re-written : 



• (kj-hj) - (Aj + Rj-Y,) + H, 



y (e) _|_ y (d) — (i _ nr\ y 

V 1-V (1 L) £ (1+r)' 

V'" + Vn (<1) 

+ (l+r) : ( ' 3a) 

D 

when, after substituting 2 [kj — h 3 ) — (Aj + Rj — Yj) =*= Hj — tj] 
(i:+ r)-i for V < e > 4- V (d) - [V n (e) 4- V n < d >] (14r)-" 

2 ti(l+r)- j 
T = - !=2 (15) 

2 [(k, - h,) - (A, + R, - Y,) =F Hj] (1 + r)-J 



Similarly, equation (14) can be re-written as: 

n D. ± R 4- t V (e) 

Y (o) = (i — t ) y 3 ~ 3 3 4- — ( 14a) 

Vo (1 l.J2r ( i +re)i ^(14-r e )» (1 * aj 

when, after substituting 2 (D, ± Bj) (1 4- r e )" j for V c (e) — V (e) (1 
+ r.)- 

14 See Appendix 1 . 



Corporate Profitability Measurement 23 



2 t.j(l+r«)-i 

T e =^ i=2 (16) 

2 (DjiBj+tjMl + r.)" 1 
j = i 

Generally speaking, the expressions for T and T e that are defined 
by equations (15) and (16) are very accurately approximated by: 

n 

T = _ i=2 (17) 

SKkj-h,) -(A,+R,-Y,) +Hj] 

and, 

n 

St, 
T.=- l=i (18) 

2 [Dj ± Bj + t,] 

j = i 

This is an extremely important result 15 since it facilitates the calcula- 
tion of T and T e when, because of (sufficiently strong) multiple sign- 
changes, equations (9) and (11) yield multiple or indeterminate real 
solution values for r and r e . In the latter circumstances, equations (15) 
and (16) can obviously not be solved for T and T e . 

The effective tax rates T, and T e of the companies whose perfor- 
mances are reported in this paper are in fact computed on two bases, 
first, as illustrated in exhibit l 18 and, thereafter, in accordance with 
equations (17) and (18), respectively. The tendency for the former 
method of calculation to understate the latter is ascribable to the fact 
that the cash-flow earnings defined by exhibit 1 ignore periodic liquid- 
ity changes, h= Hj. As indicated by equations (9), (10), and (11), 
such changes should clearly be taken into account. 

EFFECTIVE INTEREST COVER AND DEBT-EQUITY SUBSTITUTION 

Interest cover is widely regarded as a measure of a firm's ability to 
meet its interest payments on a continuing basis. A more comprehen- 
sive idea is that of debt-servicing potential which includes a firm's 
capacity to meet its contractually determined debt-retirement schedules 
with or without resorting to external finance. 

The distinction between interest cover and debt-servicing ability is 

15 See Appendix 2. 
" See p. 26. 



24 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



by no means clearly denned. Thus, interest rates embody expected 
inflation, and interest payments therefore include an element of cap- 
ital repayment in addition to the conventional debt-retirement schedule 
per se. Put another way, if a sequence of interest payments Fi, 
F 2 , .... F n , is re-expressed at a base-year price level (say that of mid- 
year n), the resultant sequence F/, F 2 ', . . . . , F n ' mainly represents the 
repayment of lenders' capital. 17 The noncapital element of the latter 
sequence may be assumed to comprise the personal taxes that lenders 
succeed in shifting forward into interest rates 18 and a premium that is 
commensurate with market risk and debt level of the firm in question. 

If the proportion of the inflation-adjusted interest payment, F/, 
which compensates for personal taxes and market risk is y i} the capital 
repayment is (1 — yj) F/. If the latter amount is not replaced by an 
equal tranche of new debt, then ceteris paribus, a firm's debt ratio 
will fall. 

Under a neutral corporate tax system, wherein no element of the 
conventional interest payment, F j5 is tax deductible, the limit to a 
firm's ability to pay the noncapital component, yj Fj, is the size of its 
stream of post-tax entity earnings, (kj — hj) — (Aj + Rj — Yj) -»- Hj 

— tj, and "pure interest cover" may be defined as yj Fj/[(kj — hj) 

— (Aj + Rj — Yj) ^ Hj — tj]. In such a tax regime, debt-equity sub- 
stitution occurs when : 

(kj - hj) - (Aj + Rj - Yj) * H, - t, - yj F, - (Dj =h B,) > 

(l-yj)Fj (19) 

and the resultant difference is financed with further debt (Nj ± Mj) 

— (1 — yj)Fj, that is, with debt over and above that which is neces- 
sary to restore the amount, (1 ~ yj) Fj, which is repaid via the con- 
ventional interest payment, Fj. 

In most corporate tax regimes, the conventional interest payment, 
Fj, is wholly tax deductible. Hence, if lenders are fully aware of the 
tax subsidy obtained by debt financing and are always willing to re- 
store (1 — yj) Fj with new debt, then if dividend policy, Dj ± Bj, is 
predetermined, the maximum conventional interest payment, Fj*, that 
can be paid in any year j without resorting to debt-equity substitution 
is given by : 

"Following the indexation procedure described earlier, Fj' = Fj In/Ij (j = 1, 

2,....,n). 

18 See R. C. Stapleton and C. M. Burke, Tax Systems and Corporate Financing 

Policy, Mongraph Series in Finance and Economics (New York: New York 

University, 1978). 



Corporate Profitability Measurement 25 



(k, - h,) - (A, + R, - Y,) T Hj - Fj* - TjPEjW - Fj*] 

-(DjiB,) -(l-yj)F,=0 (20) 

when, 
F * _ (kj ~ h t ) - (A, + R, - Yj) 3= Hj - TjEj*" - ( Dj ± Bj ) 

n ~ T J (20a) 

where, in year j, Tj and Ej (t) denote the corporate tax rate and tax- 
able earnings before interest, respectively. Any excess of actual inter- 
est, Fj, plus dividends (net of new equity), Dj ± Bj, over Fj* results 
in debt-equity substitution. 

Since, in most corporate tax regimes, an excess of conventional 
interest, Fj, over taxable earnings (before interest), Ej (t) , does not 
qualify for a corporate tax repayment, equation (20) is subject to the 
constraint : 

Tj[Ej< l) -Fj*] >0. 

The conventional interest payment, Fj, is also subject to a non-nega- 
tivity requirement because negative interest (the excess of new debt 
over conventional interest) is not taxable, that is, Fj is tax deductible 
but (1 — yj ) Fj and Nj + Mj — (1 — yj ) Fj are not subject to corpo- 
ration tax. 

Apart from indicating the maximum conventional interest payment, 
Fj*, which can be made in any year j, inequality (19) also indicates 
the degree of debt-equity substitution that may be associated with any 
given levels of interest, Fj, and shareholder cash flows, Dj ± Bj. Thus, 
if 

(kj - hj) - (Aj + Rj - Yj) + Hj - yj Fj - Tj |E,<« - Fj] 

-(Dj±Bj)<0 (2 0b) 

debt-equity substitution has taken place. 

Practical notions of interest cover do not usually distinguish between 
the "pure interest payment," yjFj, and the capital repayment (1 — 
yj)Fj, since it cannot always be taken for granted that (1 — yj)Fj will 
be restored by lenders. Contractually determined interest and debt 
retirement schedules are commonly mirrored in standards for assessing 
a firm's ability to service such preferential charges from internally gen- 
erated funds. 

Given the level of investment, 19 the limit to a firm's ability to ser- 

18 In examining a firm's ex post debt servicing capacity, the level of investment is 
a fact. From a managerial standpoint, there may be quite significant discretion 
with respect to the level of investment. 



26 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



vice and retire debt from internally generated finance depends upon 
the ratio of tax-deductible (conventional) interest payments, Fj, and 
loan repayments, Nj + Mj to entity cash-flow earnings. If Fj can be 
tolerably approximated from existing and probable future commit- 
ments then, earnings volatility aside, the maximum internally financed 
loan repayment, Nj* + Mj*, in any year j is simply: 

Nj* + Mj* = (kj - hj) - (Aj + Rj - Yj) + Hj - Fj 

-Tj[Ej<t>-Fj]. (21) 

SUMMARY OF AGGREGATE DATA ANALYSIS 

This part summarizes the aggregate data analysis that is reported in 
detail elsewhere. 20 

The historic cost accounting performance of quoted companies in 
the U.K. manufacturing sector during the period 1954-76 can be jux- 
taposed with their cash-flow performance as in exhibit 1. 



Exhibit 1. U.K. Quoted Manufacturing Companies: Weighted Average 
Profits and Weighted Average Cash Flows 1954-76" 

Pre-depreciation profit 1,000 860 Operating cash flow 
Depreciation 310 453 Capital expenditure 

Profit before interest 690 407 Entity earnings b 

less interest 97 97 less interest 

Pre-tax profit 593 310 Pre-tax equity earnings 

Tax @ 44% 260 260 Effective equity tax burden @ 84% c 

Post-tax profit 333 50 Post-tax equity earnings 

Dividends (40%) 133 133 Dividends (net of new equity capital) 

26 Liquidity change 

Retained earnings 200 (109) (Debt-financed deficit) 



a Twenty-three-year averages of profits and cash flows initially restated at base-year prices 

(see exhibits 2 and 3). 

b Operating cash flow minus net capital investment [see identity (4), p. 3J. 

c The effective entity tax burden in this example is 64 percent, namely, 260/407. 

From 1954 to 1976, the market value of the companies' equity shares declined by 38 percent 

in real terms, after allowing for capital gains tax. 



As virtually all the conclusions which emerge from this paper are 
concerned with the deviation between pretax historic cost profit and 
entity (cash-flow) earnings, it is appropriate to reiterate that the two 
components of this deviation are (a) periodic working capital invest- 
ment, that is, periodic change in (receivables plus inventories less 

M See Lawson, "Company Profitability." 



Corporate Profitability Measurement 27 



payables), and (b) a depreciation shortfall equal to periodic capital 
investment (net of displacements) minus periodic depreciation (in- 
cluding accounting profits or losses on assets displaced. 21 At the aggre- 
gate level, the annual values of (a) and (b) have been roughly equal 
since 1954. 

The customary objection that the latter definition of a depreciation 
shortfall ignores the unexhausted benefits of periodic capital expendi- 
ture is, as already discussed, accommodated by taking cognizance of 
the entry and exit market values of debt and equity capital. Like 
identities (1) to (5) inclusive, the right-hand column of exhibit 1 
therefore reveals the earnings (or, more precisely, the constituents 
thereof) that are distributable from a company's standpoint. 

In emphasizing that exhibit 1 is a caricature of the multiperiod 
aggregate performance, summarized in exhibits 2 and 3, at least two 
further qualifications should be entered. First, the twelve months' 
average time lag between the charging and payment of corporate 
taxes has been ignored in exhibit 1 in order to draw the possible deci- 
sion-making consequences of the deviation between pretax profit and 
entity earnings into sharper focus. In all analysis contained in this 
paper, this time lag has been explicitly taken into account. 

Secondly, and as already noted, the two effective rates of tax (on 
cash-flow earnings) defined in exhibit 1 are approximations which 
tend to understate the average multiperiod rates of tax defined by 
equations (13) and (14), respectively. 22 Both methods of computing 
effective tax rates are adopted hereafter. It should also be noted that 
if, as depicted in exhibit 1, dividends persistently exceed post-tax equity 
earnings, the effective equity tax rate will typically be lower than the 
effective entity tax rate. This follows from the definitions of effective 
tax rates that were derived earlier. 

If, as is indeed the case, exhibit 2 accurately reflects the main fea- 
tures of the 1954-76 financial performance and financial behavior of 
U.K. manufacturing companies then, at this level of aggregation: 

1. The cover for conventional interest payments has been overstated; 

2. Enormous fiscal drag has taken place ; 

3. Dividends have been significantly uncovered; and 

4. The resultant deficit financing by lenders has caused a significant 
increase in debt levels, that is, debt-equity substitution has occurred. 

" See the section on pages 14 through 16. 
a See page 22. 



28 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



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30 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Other things being equal, the substitution of debt for equity will 
result in an increase in the value of debt and, tax effects aside, an 
equal reduction in the market value of equity. The substantial decline 
in the (real) market value of equity (see exhibit 5) that has taken 
place in the United Kingdom since April 1965 has not been offset by 
an equal increase in the market value of debt. 23 The debt-equity sub- 
stitution argument therefore should be supplemented with, for exam- 
ple, a decline in the quality of entity earnings. 24 

Exhibit 4. Real Rates of Return from Manufacturing Companies 1954-76 

I. Market values of capital at December 1974 prices 

Entity Debt Equity 

£m. £m. £m. 

April 1954 31,264 2,385 28,879 

April 1965 53,449 5,841 47,608 

April 1977 27,233 9,276 17,957 

II. Rates of return in real terms (net of all taxes) 

Entity Debt Equity 
% p.a. % p.a. % p.a. 

1954-64 6.2 3.1 6.6 

1965-76 -3.9 z 03 -4.6 

1954-76 1.4 -0.2 1.9 

Notes 

i. Entity and equity values at 1977 are net of capital gains tax at 17 percent on share-price 
appreciation (measured in money terms) from April 1965 to April 1977. 

ii. The 1977 values are derived by capitalizing proposed dividends and interest at the April 1977 
dividend and redemption yields. The equity values for earlier years are deduced from the 
de Zoete Equity Index. 

iii. Debt includes bank overdrafts and short-term loans, both of which are extracted from the 
published aggregate balance sheets for each of the three years. The market values of long-term 
debt in 1954 and 1965 represent published long-term interest capitalized at the respective de- 
benture yields published in those years. 

iv. The rates of return for each of the three periods shown are the internal rates of return 
which equate the "entry" values with the stream of cash flows and "exit" value corresponding 
thereto. (See page 17.) The respective cash-flow streams are shown in exhibit 3, column 6 
(entity), column 9 (debt), and column 10 (equity). 

Aggregate Cash-Flow Data and the Efficient Market Hypothesis 

The enormous deviations between the historic cost and cash-flow mag- 
nitudes shown in exhibit 1 prompt one to question whether, like 
lenders, the British Treasury, and company directorates, the market 
has also been fooled by the historic cost-accounting model. 

The time-series relationship between the income-gearing ratio 25 

■ 3 See exhibit 4. 

"Lawson, "Company Profitability," pp. 30-37. 

25 Conventional interest divided by entity earnings (as defined in exhibit 1). 



300 



200 



100 
80 

60 
50 

40 

30 



Corporate Profitability Measurement 31 



Exhibit 5. Equity Price & Income Indices Adjusted for Cost of Living 

300 







d equity inc 

- •/ 










^^-'N 








\y \"** '• 


^ 




V / 












/ 


\ / 












/ 


v/ 












xx 








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\ 


f v ^ 










ted equity p 




/ 








JUS 




' 


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1 1 1 1 


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i i i i 


i i i i 



200 



H 100 

80 

60 
50 
40 

30 



1950 1955 1960 1965 1970 1975 

Reproduced with the kind permission of de Zoete & Bevan London from Equity and Fixed In- 
vestment from 1919 (January 1980) , p. 4. 



and equity earnings on the one hand, and the behavior of the de Zoete 
Equity Index (expressed in real terms) on the other, suggests that a 
combination of low-equity earnings and high-income gearing is, rela- 
tively speaking, usually associated with a low end-year index value 
and vice versa. This raised the presumption that the data may afford 
at least a rough-and-ready statistical test of the following semistrong 
version of the efficient market hypothesis. 26 

In forming its expectations of future dividends, the market uncovers 
a company's past and current underlying cash-flow situation and, using 
this and all other relevant known and knowable information, estimates 
the size and quality of its future cash flows. This process results in the 
simultaneous determination of its share prices. 

To test this hypothesis, the following multiple regression (adaptive 
expectations) model was used : 



EIj = Xl + x 2 ECFEj + x 3 ECFEj.i - x 4 CV (j , 



3-3) 



(I) 



26 The test is rough-and-ready because aggregate data are basically unsuitable for 
the task. Thus, the accounts for each individual company included in the sample 
are for accounting years which end between 6 April of the year shown and 5 
April in the following year. The aggregatetd accounts for the years shown there- 
fore span a period of twenty-four months. For example, a company making up its 
accounts to 10 April 1954 would be included in the year 1954, as would a com- 
pany reporting on a financial year ending 31 March 1955. Each individual 
sample year therefore includes accounts for the last nine months of the previous 
calendar year and for the first three months of the succeeding calendar year. 



32 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



where, 

EIj denotes the (January 1st) level of the de Zoete cost of 
living-adjusted equity price index for year j ; 
EGFEj denotes post-tax equity cash-flow earnings in year j as 
defined by identity (3) ; 27 and 
CVfjj-s) represents the coefficient of variation of the past four 
years' equity cash-flow earnings about their four-year 
mean. 

The previous year's ECFE is used as a proxy for the expected value 
of equity cash-flow earnings estimated by the market in the individual 
year in question. The coefficient of variation, CV, is a proxy for the 
degree of risk which characterizes expected equity cash-flow earnings 
which, in turn, may be assumed to be a function of the volatility of 
post-tax entity income and of the expected income gear ratio. 

A trend in both the EI and ECFE series could give spurious corre- 
lation in the data and lead to misleading statistical results. To avoid 
this, the raw data were differenced, 28 and the resultant series was used 
for statistical testing. Differencing does not change the model — the 
model indicates the change over the year which, together with the 
previous year's absolute figure, gives the current year's actual value 
for the series. 

In that the suggested model explains approximately 60 percent of 
the movements in EI, it stands up quite well to the data. The results 
(using the backshift operator) are: 

(l-B)EIj =3.142 + 0.744(1- B)ECFEj + 0.0385(1 - B)EGFEj-i - 19.15(1 - B)CVu.j- 3 ) 
(st. errors) 0.0159 0.0163 15.13 

(t ratio) 4.675 2.364 1.266 

R-squared = 0.6012; Durbin- Watson statistic = 2.043; degrees of free- 
dom 18 — 3; and F test = 8.70. 

Having established the model, it was further tested on random 
samples of the data points. The results were encouraging in that only 
the constant varied substantially (its range was 32 to — 4), and the 
R-squared was always above 0.58. 

The cash-flow hypothesis may be tested indirectly by regressing an 
equity price index expressed in money terms on the historic cost ac- 

" Whereas EI is the level of the index on 1 January, ECFE denotes earnings 
aggregated over a two-year period ending three months later (see previous 
footnote ) . 

38 Differencing means that the change in the series over the year is used instead 
of the absolute value. This is represented by the backshift operator, B, where 
(1 — B)Xj = Xj — Xj-i, the difference over the year in series Xj. 



Corporate Profitability Measurement 33 



counting variables corresponding to those included on the right-hand 
side of equation ( I ) . Such a model is : 

EI(m)i = Xl + x 2 HGPj 4- x 3 HCPj-x - x 4 GV ( j,j- 8 ) (II) 

where, 

EI(m)j denotes the level of de Zoete equity price index (on 1st 
January) expressed in money terms for year j; 
HCPj stands for actual historic cost profit (that is, not re-ex- 
pressed at base year prices) for year j ; and, 
CV(j,j_3) represents the coefficient of variation of the past four 
years' historic cost profits about their four-year mean. 

The results yielded by model II are counter-intuitive. 29 They are: 

(1 - B)EI(m) j = 106.94-0.085(1 - B)HCPj - 0.701(1 - B)HCPj-i + 777.02(1 - B)CVo.j-» 
(st. errors) 0.1955 0.21404 1118.1 

(t-values) 0.433 3.276 0.695 

R-squared = 0.3162; Durbin-Watson statistic = 2.836; degrees of free- 
dom 18 — 3; and F test = 3.62. 

It is tempting to conclude that cash-flow data re-expressed in terms 
of a base-year price level constitute highly relevant information for 
stock market investors, and that historic cost accounts per se are ap- 
parently ignored by the market while being taken seriously by lenders, 
company directorates, and the tax authorities. 

ANALYSIS OF INDIVIDUAL COMPANY DATA 

As previously noted, the relative orders of magnitude shown in the 
right-hand column of exhibit l 30 reveal the weighted average cash- 
flow performance of U.K. -quoted manufacturing companies during 
1954-76. The extent of the dispersion about this average across com- 
panies is clearly of interest. To reveal dispersion, the accounts of nine 
of the companies that are included in the F.T. 30 Share Index were 
restated on a multiperiod cash-flow basis in both money and real terms. 
The companies selected and the inclusive years covered are : 

Blue Circle (1959-77) Bowater (1961-78) John Brown (1965-79) 
Coats Patons (1962-78) Dunlop (1960-78) E.M.I. (1961-78) 

I.C.I. (1961-78) Plessey (1963-79) Tesco (1960-79) 

The analyses of their cash flows, restated at December 1978 prices, are 
summarized in exhibit 6. 



28 That is to say, the signs preceding the second, third, and fourth coefficients 
are the wrong way around. 
30 See page 26. 



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Corporate Profitability Measurement 35 



To supplement the individual company (multiperiod) cash-flow 
analyses, their annual (equity) market values were ascertained and, 
like the cash flows, restated at a base-year price level. An indication 
of the behavior of the total (real) market values (debt plus equity) 
of the nine companies over the respective observation periods is pro- 
vided by exhibit 7 which also shows the real rates of return they gen- 
erated for their lenders and shareholders. 

Apart from examining for dispersion about the averages, shown in 
exhibit 1, a further aim was the formulation of a multiple regression 
model which hopefully would explain the serial behavior of a com- 
pany's equity market value in terms of its equity cash-flow perfor- 
mance. A long search for such a model has not proved fruitful. Alter- 
native specifications will be tried in the near future. As there is a 
stronger visual correlation between the equity cash flows of individual 
companies and their equity market values than between the latter and 
historic cost profits, there is a presumption that the appropriate model 
will be a cash-flow specification. But if any model is to provide a con- 
vincing explanation of the relationship between performance measured 
in accordance with some accounting method and stock market per- 
formance, it will need to take cognizance of post-tax earnings, risk 
and debt-equity substitution. 

FINANCIAL ANALYSIS OF INDIVIDUAL COMPANY DATA 
Interest Cover 

The "quasi-conventional" interest cover ratios that may be derived 
from exhibit 6 (row 1 divided by row 2) suggest that seven of the nine 



Exhibit 7. Market Values and Internal Rates of Return at December 1978 Prices 





Opening vat 


lues 


Closing values 


Rates of return* 




Debt 


Equity 


Entity 


Debt 


Equity Entity 


Debt b 


Equity 


Entity 




£m. 


£m. 


£m. 


£m. 


£m. 


£m. 


% 


% 


% 


Bowater 


228 


468 


696 


258 


293 


551 


—5.3 


— 5.4 


— 5.2 


John Brown 





89 


89 


10 


98 


108 


* 


1.6 


+ 0.6 


Coats Patons 


27 


460 


487 


57 


203 


260 


—8.3 


+ 3.0 


— 2.4 


Dunlop 


87 


224 


311 


236 


103 


339 


—2.4 


— 3.5 


— 2.9 


E.M.I. 


17 


179 


196 


146 


156 


302 


—5.0 


— 6.1 


- 5.7 


I.G.I. 


281 


3,670 


3,951 


750 


2,205 


2,955 


—9.9 


— 1.3 


— 3.0 


Plessey 


61 


230 


291 


56 


195 


251 


—4.1 


— 1.9 


— 2.8 


Tesco 


1 


10 


11 


10 


221 


231 


—6.6 


+ 18.5 


+ 18.0 


Blue Circle 


8 


416 


424 


86 


202 


288 


—2.6 


— 1.4 


— 1.6 



■ Computed in accordance with equations (9), (10) and (11), p. 18. 
b Net of tax on interest payments at the rate of 23 percent. 
e Net of tax on dividend payments at the standard rate of income tax. 
* Indeterminate. 



36 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 8. "Quasi-Conventional" Interest Cover Ratios 







Interest 


Interest 


Inclusive 




cover ratio 


cover ratio 


years 




(see note) 


since 1974 


1961-78 


Bowater 


0.85 


1.59 


1965-79 


John Brown 


1.70 


2.80 


1962-78 


Coats Patons 


3.80 


4.82 


1960-78 


Dunlop 


1.17 


1.04 


1961-78 


E.M.I. 


0.53 


1.58 


1961-78 


I.C.I. 


2.40 


2.04 


1963-79 


Plessey 


1.82 


3.04 


1960-79 


Tesco 


00 


00 


1959-79 


Blue Circle 


3.92 


5.28 



Note. Derived from exhibit 6 (row 1 -$- by row 2). 



companies had (conventional) interest charges on internally generated 
funds that were significantly higher than is generally perceived as 
normality by lending institutions (see exhibit 8). In that the decisions 
to lend to the nine companies in question would have been influenced 
by conventional historic cost-interest cover yardsticks, such an outcome 
would have been virtually inevitable. 

In that the stock appreciation tax reliefs that were introduced in 
November 1974 have ameliorated the pressure on corporate financial 
viability, the interest cover ratios that have emerged since that date 
are of particular significance. These are separately indicated in exhibit 
8. In six of the nine cases, the ratios of conventional interest to in- 
ternally generated funds have strengthened since 1974. Those of I.C.I. 
and Dunlop have deteriorated. Except for Coats Patons and Blue 
Circle, the values shown in the second column of exhibit 8 are much 
lower than the conventional interest-cover yardsticks derived from 
the companies' published accounts. Moreover, as discussed in the con- 
cluding section of this paper, the joint effect of interest and tax com- 
mitments is the crucial consideration in assessing a company's financial 
viability. 

Effective tax rates. As the analysis of tax rates implies, (effective) 
corporate tax rates may reflect either equity or entity concepts of 
cash-flow income. The distinction between the equity tax rates de- 
fined by equation (18) 31 and exhibit l 32 should also be emphasized. 
The T e defined by equation (18) measures the rate of tax on equity 

31 See page 23. 
35 See page 26. 



Corporate Profitability Measurement 37 



Exhibit 9. Effective Rates of Tax on Equity Earnings 



(1) 




Inclusive 




1961-78 


Bowater 


1965-79 


John Brown 


1962-78 


Coats Patons 


1960-78 


Dunlop 


1961-78 


E.M.I. 


1961-78 


I.C.I. 


1963-79 


Plessey 


1960-79 


Tesco 


1959-79 


Blue Circle 





(3) b 


since 


1974 


(2)' 


(4) c 


(5)< 


% 


% 


% 


% 


00 


144 


177 


109 


136 


79 


16 


1,766 


109 


72 


66 


76 


744 


96 


1,816 


104 


00 


196 


282 


140 


143 


80 


146 


94 


316 


149 


91 


89 


67 


81 


51 


59 


100 


74 


53 


71 



tt Computed in accordance with exhibit 1, p. 26, and deri%'ed from exhibit 6 [row 4 -r- row 3]. 

b Computed in accordance with equation (18) and derived from exhibit 6 [row 4 -J- (row 4 + 
row 7)]. 

c Computed as in column (2) above using only the post-1974 data included in exhibit 6. 

d Computed as in column (3) above using only the post-1974 data included in exhibit 6. 



capital and, among other things, will indicate when taxation has be- 
come confiscatory and therefore a deterrent to equity investment. As 
previously described, T e embodies share-price appreciation (or depre- 
ciation). This explains why shareholders may receive cash from their 
companies year in, year out, while sustaining both taxes at rates exceed- 
ing 100 percent and negative rates of return. 

The equity tax rate defined by exhibit 1 lacks the rigor of T e . The 
exhibit 1 equity version nevertheless facilitates a comparison with the 
conventional approach to the measurement of the corporate tax burden 
and, in treating interest payments as a tax-deductible expense, provides 
some indication of the effect of taxes on corporate financial viability. 

Columns (2) and (3) of exhibit 9 show the (average) effective 
rates of tax [calculated in accordance with exhibit 1 and equation 
(18), respectively] on the equity cash-flow earnings of the nine com- 
panies in the sample for the inclusive years indicated in column ( 1 ) . 
Columns (2) and (3) both suggest that the U.K. corporate tax system 
virtually confiscated equity earnings. 33 If so, dividends (net of new 
equity raised) could only have been paid from new debt. 

In the discussion of effective interest cover and debt-equity sub- 
stitution on pages 23-26, it was argued that if company cash-flow per- 
formances are restated at a base-year price level, that is, in real terms, 

33 In that all nine companies generated a significant proportion of their income 
abroad, this proposition should be qualified accordingly. 



38 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



interest payments (for example, those disclosed in exhibit 6) mainly 
represent the repayment of lenders' capital. Thus, leaving aside the 
fact that corporate debt is not risk free and that interest payments 
may therefore embody a risk premium, corporate taxable capacity 
should, so the argument runs, be measured on an entity basis. A coun- 
ter-argument that follows from the discussion of the real cost of debt 
is that an effective equity tax rate calculated in accordance with 
equation (18) fully allows for repayments of lenders' capital which 
amounts are reflected in share values. 34 Be this as it may, an entity 
concept of taxable capacity is defensible in its own right. That is to 
say, a firm's taxable capacity should be measured independently of the 
manner in which that firm is financed — there should be no tax dis- 
crimination in favor of debt. 

While maintaining the general substance of the analysis of effective 
interest cover and debt-equity substitution, (and the previous para- 
graph), we now ignore the market risk premium that may be embodied 
in the cost of corporate debt and assume that the proportion, yj, of 
interest payments, F J3 represents the personal taxes that lenders succeed 
in shifting forward into the interest rate. On this assumption, yjFj 
becomes a charge on entity earnings and should be added to corporate 
tax payments accordingly. Such an adjustment using a 23 percent per- 
sonal tax rate is included in exhibit 10. 35 

Effective entity tax rates may be derived from exhibit 10 in ac- 
cordance with exhibit 1 and equation (17), respectively. The relevant 
figures are shown in exhibit 1 1 . 

The effective entity tax rates shown in columns (2) and (3) of 
exhibit 11 provide compelling evidence of the confiscatory character 
of the corporate tax regimes that have operated in the United King- 
dom in the last two decades. Moreover, the values in columns (4) 
and (5) of exhibit 11 strongly contradict the new conventional wisdom 
to the effect that the 1974 stock appreciation relief has roughly elimi- 
nated the effects of inflation on taxable earnings. 36 

In concluding this discussion of corporate taxes, mention must be 
made of the popular view that the only corporation tax paid by com- 
panies is the advance corporation tax (ACT) that is simultaneously 

M See pages 20-23. 

* Judging from the evidence cited in Stapleton and Burke, 23 percent is a 

conservative estimate of the tax shifted forward into interest rates. 

** This view was recently reiterated by the governor of the Bank of England. See 

G. Richardson, "Companies, Inflation and Taxation," Bank of England Quarterly 

Bulletin (December 1979): 409-15. 



Corporate Profitability Measurement 39 



3 



10 — 

CM CM 
+ 1 



co cn^m 



^s +1 



a-Oj r^CM 

£t>. . on 

3 co S >n M 

ea +1 



^tO^,} CM — 

-2 +1 



"SioC} 

h35 



+ 1 



cp.c OCO 
a^o^j coco 

QS +1 



+ 111 



o cor^m 



+ +I 



++I 



+ 111 



I 1 + 



I +1 



++I 



++I 



++I 



++I 



Coats 
Patons 
1962/78 

£m. 


01(0 


eo r^-co — 

CM ^CMlO 


CO 


mmo 
cooo 


COCO 
COCO 

+ 1 


m ocmo 

+ M 1 


1 


r~coi-~ 
++I 



3K . 



•*eo 
+ 1 



CO-* 



|g<-tf MCO 

ǤS +| 



I l + l 



++I 



+ 



-« & w 






**• 

in 


omo 




— 


OOO 





1 


++I 


+ 



v 5 

•a -2, 



&,Qj3 Q « 



cotj-io to 





— mcM 


CO 


~ 


■*r^o 

— — CM 


— 


1 


++I 


+ 



CM 0">OCM 




mo — 


— OO — 
+ 111 


T 


CM — CM 

++I 



s « 

e 

J .5 






ass 

if® 
2 8" 3 






40 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 11. Effective Rates of Tax on Entity Earnings 



(1) 




Inclusive 


years 


1961-78 


Bowater 


1965-79 


John Brown 


1962-78 


Coats Patons 


1960-78 


Dunlop 


1961-78 


E.M.I. 


1961-78 


I.C.I. 


1963-79 


Plessey 


1960-79 


Tesco 


1959-79 


Blue Circle 





(3) b 


since 1974 


(2)- 


(4) c (5) d 


% 


% 


% % 


149 


233 


80 95 


69 


110 


19 352 


86 


88 


57 63 


127 


142 


105 143 


435 


1,723 


118 143 


93 


139 


86 146 


155 


175 


68 80 


67 


87 


51 76 


80 


89 


47 72 



■ Computed in accordance with exhibit 1, note 3 (after adjusting for personal taxes), and 

derived from exhibit 10, that is, row (2) divided by row (1). 

b Computed in accordance with equation (17) and derived from exhibit 10, that is, row (2) 

divided by [row (1) plus row (5)]. 

c Computed as in column (2) above using only the post-1974 data included in exhibit 10. 

d Computed as in column (3) above using only the post-1974 data included in exhibit 10. 



payable with dividends. As exhibit 10 suggests, and as is confirmed by 
an examination of each individual year's data since 1974, the ACT 
paid by all nine companies has represented only a small fraction of 
their total corporate tax burdens. 

Dividend cover and debt-equity substitution. A comparison of lines 
6 and 7 in exhibit 6 suggests that Tesco alone succeeded in covering 
its average dividend payment over the years in question. (The share- 
holders of Bowater, E.M.I., and Plessey were net cash-flow contribu- 
tors over the respective eighteen-, eighteen-, and seventeen-year periods 
analyzed.) 

Assessing dividend cover by reference to exhibit 10, column 6 [that 
is, in accordance with inequality (20b)], 37 all nine companies engaged 
in debt-equity substitution (on average every year) over the respective 
periods considered. However, the shareholders (including minorities) 
of Bowater, Dunlop, E.M.I., and Plessey were annual cash-flow con- 
tributors (on average), and debt-equity substitution was dividend in- 
duced (including payments to minorities) to the extent of 63, 32, and 
77 percent of dividends in the cases of Coats Patons, Tesco, and Blue 
Circle, respectively. In the two other cases (John Brown and I.C.I. ), 
dividends were wholly debt financed. 

If dividend policy is an active decision variable and is based on 
historic cost profits, debt-equity substitution is the predictable outcome 

" See page 25. 



Corporate Profitability Measurement 41 



mentioned at the outset. While the level of debt raising was trivial in 
Tesco's case, the changes in the relative market values of debt and 
equity (shown in exhibit 7) 38 are generally consistent with a significant 
degree of debt-equity substitution stemming from uncovered dividend 
payments. 

Since 1974, the shareholders of Bowater, John Brown, Dunlop, and 
E.M.I, have been net cash contributors and these companies have, on 
average, also raised debt in each year during the period. During this 
period, the dividends paid to the shareholders of Coats Patons, I.C.I., 
Plessey, Tesco, and Blue Circle were debt-financed to the extent of 
29 percent, 100 percent, 41 percent, and 89 percent, respectively. 

Market values. The entity market values of Bowater, Coats Patons, 
I.C. I., Plessey, and Blue Circle declined in real terms over the periods 
considered. In the cases of Coats Patons, I.C. I., and Blue Circle, real 
debt levels rose significantly causing a reverse leverage effect on their 
equity market values. The percentage declines in the latter were 28 
percent, 54 percent, and 40 percent for Coats Patons, I.C. I., and Blue 
Circle, respectively. Notwithstanding net cash-flow contributions from 
their respective shareholders, there were real declines in the market 
values of both debt and equity in the cases of Bowater and Plessey. 

The real increase in the entity market value of E.M.I, must be 
qualified by the fact that its shareholders were net cash contributors 
over the eighteen-year observation period. Notwithstanding this equity 
cash injection, its equity market value declined by 13 percent in real 
terms. 

The entity market values of the three remaining companies, namely, 
John Brown, Dunlop, and Tesco, increased in real terms. In the cases 
of John Brown and Tesco, the real market values of both debt and 
equity showed increases. In Dunlop's case, an increase in entity market 
value was associated with a 271 percent increase in the market value 
of its debt and a 54 percent decline in the market value of its equity 
which, in 1978, constituted 22 percent of its total market value. 

Taking cognizance of the debt ratios of Bowater, Dunlop, and 
E.M.I., expressed on a market value basis, it is reasonable to question 
whether these companies may not be geared to precarious levels. Their 
debt levels constituted 53 percent, 78 percent, and 52 percent of their 
respective entity values at their 1978 financial year ends. 

Implicit in the foregoing paragraphs and in the discussion in the 
earlier sections is the proposition that (real) multiperiod cash-flow 

88 See exhibit 7. 



42 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



analyses and (real) changes in market values are integrally related. 
Viewed on its own, the multiperiod cash-flow analysis understates the 
financial performance of four of the companies in the sample and over- 
states it in the case of the other five. The degree of profitability 
achieved by the nine companies over the respective (roughly eighteen- 
year) periods considered is more decisively indicated by the real rates 
of return shown in exhibit 7. 39 On these criteria, shareholders did 
slightly better than lenders and only Tesco and John Brown were 
profitable as entities over the period as a whole. 

CONCLUSION 

It should be questioned finally whether the combination of interest 
and taxes that is borne by U.K. companies is a dangerous threat to 
their financial viability. Notwithstanding the obligation under debt 
contracts to pay interest payments which effectively provide for the 
return of lenders' capital as a prior charge on equity cash-flow earn- 
ings, the interpretation afforded by exhibit 10 (line 1 — line 2) prob- 
ably represents the most appropriate statement of corporate financial 
viability in a fundamental economic sense. Over the respective (roughly 
eighteen-year) observation periods, four companies, namely, Bowater, 
Dunlop, E.M.I., and Plessey were, judged by the latter criteria, not 
financially viable. 

Since 1974 the position has improved. Only Dunlop and E.M.I, 
seem, on average, to have satisfied the above definition of corporate 
bankruptcy. 40 It is, however, noteworthy that both of these companies 
generated positive pretax entity earnings in three of the four years 
between 1974 and 1978. Their annual averages for this four-year period 
were £39. 2m. and £23.45m. respectively compared with the £30.7sm. 
and £4. 79m. shown in exhibit 10 (for periods of nineteen and eighteen 
years, respectively). It may therefore be concluded that the U.K. cor- 
porate tax system still lacks the inbuilt safeguards that would prevent 
it from converting financial viability into corporate bankruptcy. 41 

It must also be added that companies cannot rely on the possibility 
that lenders will always modify debt contracts in accordance with the 
notion of "corporate financial viability in a fundamental economic 
sense" and will usually be more impressed by lines 1 and 2 of exhibit 

M Ibid. 

*° See exhibit 11, column (4). 

41 As shown elsewhere (See Lawson, "Company Profitability," pages 30-37), the 

U.K. system of corporation tax also increases the volatility of past tax company 

earnings. 



Corporate Profitability Measurement 43 



6. When conventional interest payments exceed adjusted taxes, finan- 
cial viability is obviously more stringently evaluated by the latter 
comparison. 

There is also the point that taxable capacity is measured indepen- 
dently of cash-flow interest cover. Thus, the combined, legally enforce- 
able burden of interest and taxes may be potentially overwhelming in 
many cases in practice. Column (4) of exhibit 9 42 suggests that this 
could be true of Bowater, Dunlop, E.M.I., I.C.I., and Plessey. It says 
much (or little) for the U.K. lending mechanism that such companies 
do not encounter serious financial trouble. 

The implications of the results presented in this paper for the for- 
mation of expectations by businessmen are of special importance. If, 
intuitively or otherwise, businessmen are aware of the effect of a hos- 
tile fiscal environment on the returns to investment, they will respond 
accordingly. There seems little point in examining the efficiency of the 
U.K. lending mechanism 43 in seeking explanations for a low level of 
investment in circumstances in which dividends are habitually debt 
financed because the returns to equity investment are confiscated by 
the tax system. Though there is some dispersion about the averages 
revealed by the aggregate data, both the individual and aggregate re- 
sults are consistent with the hypothesis that the relatively low level of 
U.K. corporate investment has been caused by the belief that invest- 
ment is unprofitable because of confiscatory taxation. 

Turning to the role of the accountant, the evidence presented in 
the foregoing pages suggests that multiperiod cash-flow performance 
is a feature of corporate sector life which can only be ignored by 
accountants at their peril. In not fully understanding the inherent 
tendency of historic cost profit consistently to exceed cash-flow earn- 
ings, U.K. accountants have also generally failed to recognize the 
permanent threat to corporate financial viability (and corporate con- 
tinuity) posed by historic cost-based decisions at the corporate level, 
not to mention the clear implications from a managerial decision- 
making standpoint. If accountants can be taken by surprise by the 
relative orders of magnitude disclosed in this paper, their technical 
competence must be open to serious doubt. In this regard it must, of 
course, be stressed that the results reported here are derived from 
British data. While the British themselves are often quick to stress 
that things are different in Britain, there are in fact strong a priori 

42 See exhibit 9. 

43 See the terms of reference of the Committee to Review the Functioning of 
Financial Institutions. 



44 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



grounds for assuming that this paper may reveal the symptoms of a 
condition that is endemic throughout Europe and most of the English- 
speaking world. 

Britain is probably an object lesson on the economic and financial 
consequences of taxation, dividend, and lending decisions that are 
based on historic cost accounting measures (or some variant thereof). 
The British postwar experience may indeed receive a special place in 
the annals of economic history. Advanced and developing economics 
which rely on the joint stock enterprise, to organize economic activity 
and act as the engine of real economic growth, can learn much from 
the British experience. 

So too can those who reject the ethic of capitalism and seek to 
bring about the demise of capitalistic economies. As Rosa Luxemburg 
and Lenin were well aware, social, political, and economic stability 
are heavily dependent upon a stable monetary system. The second 
half of the twentieth century may well show that profligate corporate 
financial behavior, stemming from taxation, borrowing, and dividend 
policies that were wrongly based (and badly documented), has the 
same power as monetary policy as a means of destroying the political, 
social, and economic fabric of democratic societies. Thus, the desire 
of the Marxist wing of the British Labor Party to nationalize the U.K. 
banking system may not be unconnected with its long-term plans for 
the direction of the manufacturing sector. Should the substitution of 
debt for equity capital continue at its present rate, then, sooner or 
later, whoever controls the banks will also control U.K. -listed manu- 
facturing companies. 

BIBLIOGRAPHY 

Anthony W. Henfrey, Bruce Albrecht, and Paul Richards. "The U.K. Stock- 
market and the Efficient Market Model: A Review." The Investment 
Analyst, no. 48 (1977): 5-24. 

Yuji Ijiri. "Cash-Flow Accounting and Its Structure." Journal of Accounting 
Auditing & Finance, vol. 1, no. 4 (1978) : 331-48. 

G. H. Lawson. "Accounting for Financial Management: Some Tentative 
Proposals for a New Blueprint." In Problems of Investment, edited by Sir 
Robert Shone. Oxford: Basil Blackwell, 1971. 

and A. W. Stark. "The Concept of Profit for Fund Raising." Account- 
ing and Business Research ( 1975) . 

"The Rationale of Cash Flow Accounting." In Trends in Managerial 



and Financial Accounting, edited by Cees van Dam. Leiden/Boston: 
Martinus NijhofF Social Sciences Division, 1978. 
. Company Profitability and the U.K. Stock Market — An Exercise in 



Corporate Profitability Measurement 45 



Cash Flow Accounting. Manchester Business School, Research Report, 

March 1979. 
T. A. Lee. "A Case for Cash Flow Reporting." Journal of Business Finance, 

vol. 14, no. 2 (1972). 
. "The Cash Flow Accounting Alternative for Corporate Financial 

Reporting." In Trends in Managerial and Financial Accounting, edited by 

Cees van Dam. Leiden/Boston: Martinus Nijhoff Social Sciences Division, 

1978. 

Cash Flow Accounting and Corporate Financial Reporting. University 



of Edinburgh, Discussion Paper, No. 6, March 1980. 

F. Modigliani and R. A. Cohn. "Inflation, Rational Valuation and the Mar- 
ket." Financial Analysts Journal (March-April 1979). 

The Rt. Hon. G. Richardson. "Companies, Inflation and Taxation." Bank of 
England Quarterly Bulletin, vol. 19, no. 4 (December 1979) : 409-15. 

R. C. Stapleton and C. M. Burke. Tax Systems and Corporate Financing 
Policy. New York University, Monograph Series in Finance and Economics, 
1978. 



APPENDIX 1. 

Although not needed for the analysis which follows, the corresponding pretax 
entry and exit values may be defined as: 

V (e, /[1 -T e (0 >] and V n < e >/[1 -T e <»>] 

where T e <0) and T e (n) denote expected tax rates as at end-years o and n re- 
spectively. This proposition can be elaborated as follows. In the absence of 
taxes, the observable end-year o market value, P , of an expected perpetual 
income stream, xt, xj, . . . . , may be defined as : 

n Xj P — °° X] 

P ° = ,?, (T+F)l + (Tht where P » -,S« (TTT)T 



and r denotes a cost of capital that is commensurate with the risk characteriz- 
ing the income stream in question. If the expected cash flows, xj, are now 
assumed to be taxable, the position changes to: 

V =V *'(1-T) . V n 

V ° ft (l + r)i + (l + r)« 

where, V = P (1— T) and V n = P n (l— T) and T is the expected rate 
of tax. 



APPENDIX 2. 

The robustness of (17) and (18) can readily be tested by computing equa- 
tions (15) and (16) for a large range of positive and negative values (includ- 
ing zero) of r and r e respectively. The rare cases in which the values of T and 
T e yielded by equations (17) and (18) do not accurately approximate the 
respective values yielded by (15) and (16) are due to multiple sign changes 
in cash flows which ultimately result in inconsistencies between the signs of 



46 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



the right-hand sides of equations (15) and (17) and between those of the 
right-hand sides of (16) and (18). 

A clue as to why (17) and (18) are good approximations of (10) and (11) 
respectively is to be found in equations (9) and (11). Using equation (11), 
if V< e > + V< d > = V n < e > + V n < d > and if (kj - hj) - (Aj + Rj - Y,) h= Hj 
and tj are both constant then, 

(kj-h)) -(A. + Rj-Y^^Hj-t, 
r V <e) + V (d> 

v o ^ v o 

= [(k.-h,) - (A. + R.-Y,) ^HjKl-T) 
V < e) -4- V (d) 

* o ' v o 

when, 

T = 



(kj-h,) - (Aj+Rj-YjJ+H, 



Regulation of Financial Accounting: 
An International Perspective 

DHIA D. AL HASHIM* 



Accounting regulations have long been recognized in most countries as 
a means of securing the reliability of accounting reports. Harmonizing 
the manner in which reports are prepared can ensure that accounting 
regulations are of real value to their users. 

The methods of producing regulations have varied from place to 
place. In some countries, for example, the accounting profession has 
led in developing accounting regulations. In other countries, regula- 
tions are enforced on the accounting profession through legislation. In 
either case, the determining factors as to who actually establishes ac- 
counting regulations appear to be the status and the size of the account- 
ing profession in those countries. For example, the relatively small size 
of the accounting profession in Asia, Africa, continental Europe, and 
Latin America has led to a situation in which accounting standards 
have been promulgated by their individual governments. In the Anglo- 
American countries, on the other hand, accounting standards have 
been developed by the accounting profession itself. 

This paper deals with the issue of regulation of financial accounting 
in different countries, focusing on both similarities and differences. This 
review is highly relevant at a time when there is growing dissatisfaction 
both within and without the accounting profession as to the present 

* Dhia D. AlHashim is professor of accounting and director of the Center for 
International Accounting Studies, California State University, Northridge. 
An earlier draft of this manuscript was presented at the Third Annual Congress 
of the European Accounting Association, Amsterdam, the Netherlands, March 
24-26, 1980. 



48 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



processes for formulating accounting standards. With the increasing 
likelihood that governmental jurisdiction over accounting standards 
will increase, the topic becomes especially important. This paper will 
examine the financial regulations in Brazil, France, Germany, Japan, 
the Netherlands, Switzerland, the United Kingdom, and the United 
States. 

FINANCIAL REGULATION IN BRAZIL 

Accounting practices in Brazil are basically those prescribed by the 
Commercial Code, the Corporation Law of December 15, 1976, regu- 
lations of the Central Bank, and tax law. This is consistent with the 
practice in continental Europe (such as France and Germany) in 
which governmental regulations play a significant role in accounting 
matters because of the comparatively small size of the accounting pro- 
fession in those countries. The Brazilian Institute of Independent 
Auditors, in fact, plays a minor role in establishing accounting stan- 
dards and procedures in the country. 

Legal Requirements for Financial Reporting 

A corporation, sociedade anonima, is governed by Corporation Law 
No. 6404 of December 15, 1976. This law, which establishes the re- 
quirements for all corporations and groups of companies, requires the 
preparation of the income statement, the statement of changes in 
financial position, and the balance sheet. In addition, it requires the 
preparation of consolidated statements for groups of companies and 
the use of the equity method for nonconsolidated subsidiaries. These 
annual financial statements must comply with the rules established by 
the Securities Commission and must be audited by independent audi- 
tors registered with this commission. 

It is interesting to note that the 1976 Corporation Law requires that 
stockholders' equity accounts, long-term investments, deferred charges, 
and property, and plant and equipment be adjusted at the end of each 
accounting period, using a price index compiled by the government. 
The difference between the original and adjusted value of all of these 
accounts is assigned to an income statement account called "monetary 
correction." However, if an inflation gain has resulted due to this 
adjustment, the law requires that this gain be assigned to a capital 
account called "reserve for unrealized profits." In addition, corpora- 
dons are encouraged to revalue their assets at the end of each account- 
ing period based on the market values, with the contra account being 



Regulation of Financial Accounting 49 



a stockholders' equity account called "revaluation reserves." Deprecia- 
tion, in this case, would be based on the new value. 

FINANCIAL REGULATION IN FRANCE 

Financial accounting in France is greatly influenced by legislation due 
mainly to the determination of the French government to obtain data 
for social accounting purposes. To underscore this policy, French tax 
law permits the deductibility of expenses only if they are included in 
the financial statements of enterprises. In addition, the 1947 Plan 
Gomptable General (Uniform Chart of Accounts) which has been 
adopted by virtually all enterprises in the country contains a detailed 
chart of accounts and a series of model financial and statistical reports 
needed for micro- and macroaccounting purposes. 

Legal Requirements for Financial Reporting 

The first comprehensive effort to regulate accounting in France came 
in 1947 with the introduction of the Plan Comptable General by the 
National Council of Accountancy's Plan Comptable General which 
specifies accounting definitions, standards, procedures, and forms of 
financial statements. It was later revised to respond to the changing 
needs of the society. 

A French corporation, Societe Anonyme (S.A.) or Societe a re- 
sponsabilite limitee (SARL), is governed by provisions of the Law on 
Commercial Companies of July 24, 1966, as modified March 23, 1967. 
Under the 1966 law, report by management on the activities of the 
company, a trading account, a profit and loss account, and a balance 
sheet should be prepared at the end of each accounting period. Con- 
solidated financial statements are not required to be published by 
corporations. The 1967 law further requires that financial statements 
be submitted to the auditors of the corporation. 

The 1966 law regulates the appointment and the responsibilities of 
auditors. Under this law, corporations which issue stock to the public 
or which have capital exceeding F5, 000,000 must have at least one 
statutory auditor. In their report, auditors must attest to the legality 
and fairness of financial statements and management reports for each 
accounting period. 

The Accounting Profession 

The accounting profession in France has been actively involved in 
the preparation of legislation related to accounting matters. This may 



50 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



explain the reason for the readiness of the accounting profession to 
adopt accounting legislation. Therefore, the accounting standards and 
procedures adopted in France are those prescribed by the French Plan, 
the tax decree of October 28, 1965, the law of July 24, 1966, the law 
of March 23, 1967, and the Finance Acts of 1977 and 1978. Profes- 
sional institutes, however, have continued to issue numerous recom- 
mendations on proper accounting guidelines to implement and to revise 
the Plan Gomptable General and tax laws. The National Association 
of Certified Accountants and the National Council of Accountancy, 
for example, have issued many opinions and guidelines dealing with 
different aspects of accounting. 

The conservatism doctrine appears to prevail among the accounting 
profession in France, partly due to the fact that officers of a corpora- 
tion can be held legally liable for the failure of the organization to 
generate profits. This may also explain the reason behind the popu- 
larity of hidden reserves in the country. 

Recently, the French government has attempted to deal with the 
problem of inflation by issuing the Finance Acts of 1977 and 1978. 
These laws have mandated the use of current-value accounting for 
listed companies with fiscal years ended after December 1977. The 
Finance Acts also called for having primary financial statements of 
listed companies report all assets based on current replacement cost. 
However, this replacement cost cannot exceed the net book value 
multiplied by an official coefficient. A revaluation account would be 
established for the adjustment of all assets, and this account would 
be reported within the stockholders' equity of the balance sheet. 

FINANCIAL REGULATION IN GERMANY 

Accounting in Germany, as in France, is influenced to a great degree 
by legislation. In fact, most accounting standards and procedures ap- 
plied in Germany are prescribed by law. Sources of accounting regula- 
tion can be found in the Commercial Code (Handelsgesetz), the Cor- 
poration Act (Aktiengesetz), the Limited Liability Company Act (Gmb 
H Gesetz), the Publicity Law (Publizitatsgesetz), the Cooperatives Act 
(Genossenschaftsgesetz), and other laws related to specific types of 
businesses. 

Legal Requirements for Financial Reporting 

The Commercial Code requires business entities ( 1 ) to maintain books 
of accounts in accordance with the "principles of proper bookkeeping"; 



Regulation of Financial Accounting 51 



(2) to prepare annual financial statements; and (3) to retain the 
company's books and correspondence for a specific period of time. 
Sections 149 and 151 to 159 of the Corporation Act of 1965, on the 
other hand, define the accounting standards and procedures to be 
utilized in the preparation of financial statements. Furthermore, the 
Publicity Law requires businesses, on three consecutive year-end dates, 
with total assets exceeding DM125 million and annual sales of more 
than DM250 million to publish their financial statements. These state- 
ments include the profit and loss statement and the balance sheet, 
accompanied with a report from management on the activities of the 
company. An average annual number of employees of over 5,000 indi- 
viduals may substitute for one of these two conditions. However, it 
should be noted that the European Economic Community's Fourth 
Directive adopted in July 1978 requires that businesses which exceed 
the limits of two of the three criteria on the balance-sheet dates are 
obligated to publish their audited financial statements. These criteria 
are (1) balance-sheet totals more than DM2.6 million; (2) net sales 
more than DM5.2 million; and (3) an average number of more than 
fifty employees during the fiscal year. A corporation (A.G.) is further 
required under sections 331 and 332 of the 1965 Corporation Act to 
publish consolidated statements if the management of the A.G. has 
control over the operations of other companies and owns more than 
50 percent of their common stock. These consolidated statements are 
generally limited to domestic subsidiaries, however. 

The annual financial statements, together with explanatory notes 
to these statements, and the management report of an A.G. are pre- 
pared and submitted to the company's statutory independent public 
accountant (Wirtschaftspriifer) for examination. An A.G. may have 
one or more auditors elected by the stockholders at their annual meet- 
ing. The report of the auditors should disclose whether financial state- 
ments are prepared in accordance with the provisions of the law and 
whether management's report helps to give a true picture of the com- 
pany's affairs. 

The Accounting Profession 

Over the years, the accounting profession in Germany has developed 
"principles of proper bookkeeping" (Grundsaetze ordnungsmaessiger 
Buchfuehrung). These standards, however, are not equivalent to the 
"generally accepted accounting principles" in the United States, since 
German accounting practitioners are more concerned with complying 



52 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



with the different laws prescribing accounting standards and proce- 
dures than with developing proper accounting standards and proce- 
dures. In other words, in Germany "generally accepted accounting 
standards" represent those standards which are detailed by law. 

Extreme conservatism in valuation of assets and in determining in- 
come is permitted in Germany. For example, the establishment of 
secret or hidden reserves by limited liability companies, charging excess 
depreciation, and assigning lower values for current assets are en- 
couraged by law to protect creditors. In addition, accounting practi- 
tioners tend to put more emphasis on form than on substance of 
financial statements because accounting is virtually legislated in the 
country. 

FINANCIAL REGULATION IN JAPAN 

Accounting in Japan is regulated by the German-patterned Commer- 
cial Code of 1890 (as amended in September 1974), the U.S. -patterned 
Securities Exchange Act of 1948, and the Comprehensive Regulations 
for Preparing Financial Statements of 1950. In addition, tax laws in 
Japan have influenced accounting practices to a great degree (for 
example, the calculation of depreciation charges, allowance for doubt- 
ful accounts, and estimated liability for warranty expense) . 

Legal Requirements for Financial Reporting 

The "business accounting principles" were officially introduced in 
Japan in 1949 by the Economic Stabilization Board. Under these reg- 
ulations, Japanese corporations should maintain proper books of ac- 
counts and prepare the profit and loss statement, the balance sheet, 
and many other supplementary schedules at the end of each account- 
ing period. In addition, since April 1, 1977, all listed corporations in 
the country have been required to prepare consolidated financial state- 
ments. The use of the equity method of accounting for carrying the 
investment account on the books of the parent company, however, is 
optional. 

Article 32 of the Commercial Code, as amended by the Ministry of 
Finance Regulation No. 54 of September 23, 1974, attempts to ensure 
that "fair and just accounting conventions shall be taken into con- 
sideration in interpretation of provisions concerning the preparation 
of accounting books." This code requires that all business entities main- 
tain a double-entry bookkeeping system, with a general ledger and 
subledgers. All listed companies must additionally file their annual 
audited financial statements with the Ministry of Finance. 



Regulation of Financial Accounting 53 



Under the Commercial Code, a public company (Kabushika Kaisha 
Yugen Kaisha) is required to have a statutory auditor elected by stock- 
holders in the general meeting. The auditor, who is not required to be 
a professional accountant, acts as a watchdog, examining the financial 
statements of the company and reporting any violations of the law 
and/or of the articles of incorporation to the directors of the company. 
In addition, under the 1976 Law Concerning Special Exceptions to 
the Commercial Code Relating to Audit, companies with a capital of 
¥1 billion or more, companies listed on the Japanese stock exchanges, 
and companies making specific public distribution of their shares are 
all required to have independent public accountants (professionals 
appointed by the board of directors) . 

The Certified Public Accountants Law of 1948 states that indepen- 
dent accountants in Japan should be either sole practitioners or audit 
corporations (Kansa hojia). Audit partnerships are not allowed in 
the country. This independent auditor cannot serve also as the com- 
pany's statutory auditor. 

The Accounting Profession 

The Japanese Ministry of Finance exercises a tremendous control over 
the accounting profession in the country. Its authority extends to setting 
the accounting standards to be followed by the accounting profession 
through the publication of Business Accounting Principles and Audit- 
ing Standards. Furthermore, this ministry can even establish a fee 
structure binding on all independent auditors. 

The Certified Public Accountants Law of 1948 established the 
foundation for the Japanese Institute of Certified Public Accountants. 
This Institute has been mainly involved in setting the professional 
qualifications for CPAs. In addition, the Institute has issued statements, 
"Notes," on auditing procedures and rules of conduct for the profes- 
sion. 

Overconservatism is often practiced by the accounting profession 
in Japan. This can be seen, for example, in the excessive charges for 
depreciation, for "inventory price fluctuation reserves," and for allow- 
ances for doubtful accounts. These charges are normally allowed for 
tax purposes. 

FINANCIAL REGULATION IN THE NETHERLANDS 

Accounting practices in the Netherlands are not influenced by legisla- 
tion since there is no legislation in the country which specifies account- 



54 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ing standards and procedures to be utilized by business entities. The 
Commercial Code (Wetboeck van Koophandel) merely requires that 
proper books of accounts should be maintained by all enterprises and 
that accounting should be based on "sound business practice." In ad- 
dition, the Financial Statements Act of 1970 (Wet op de Jaarrekening 
van Ondernemingen) provides the requirements for the preparation 
of financial statements at the end of each accounting period. Further- 
more, under the 1970 act, a parent company may prepare consolidated 
financial statements. The lack of specific legislation regulating account- 
ing standards permits the accounting profession in the country a 
greater degree of flexibility in developing sound accounting standards. 

Legal Requirements for Financial Reporting 

There are two types of legal forms for a corporation in the Netherlands, 
namely the public limited liability company (Naamloze Vennootschap, 
abbreviated N.V.) and the private limited liability company (Besloten 
Vennootschap, abbreviated B.V.). These two forms for a corporation 
are similar to those existing in other European countries, such as 
France and Germany. Under the Commercial Code, each N.V. and 
B.V. is required to prepare a profit and loss statement and a balance 
sheet at the end of its accounting period. In addition, Article 2 of 
the Financial Statements Act of 1970 requires that 

the financial statements provide such information that a sound judgment can 
be formed on the financial position and the results of operations and, to the 
extent to which financial statements permit, on its solvency and liquidation. 

Furthermore, Article 5 of this act indicates that "the bases underlying 
the valuation of the assets and liabilities and the determination of the 
results of operations comply with standards that are regarded as being 
acceptable in economic and social life." The bases of valuation, there- 
fore, can be any of the various approaches to valuation available in 
practice which are "acceptable in economic and social life" and which 
assist the readers of financial statements to make "a sound judgment" 
on the enterprise. 

Under the Commercial Code and the Financial Statements Act of 
1970, all N.V.s (excluding subsidiaries of Dutch companies included in 
the report of another corporation and meeting specific conditions) and 
certain B.V.s (for example, those with capital stock of more than 
f500,000, or with total assets of more than f8,000,000 and more than 
100 employees) are required to have an annual audit by professional 
accountants. These professional auditors must be members of the 



Regulation of Financial Accounting 55 



Netherlands Institute of Registered Accountants (NIVRA) or persons 
permitted by the Minister of Economic Affairs to practice as auditors. 
The 1970 act requires auditors to disclose any noncompliance with the 
act in their reports. 

The Accounting Profession 

The passage of the Register Accountants Act, which became effective 
in 1963, was a cornerstone for the establishment of the NIVRA, a 
semi-governmental professional accounting body. The NIVRA has 
issued a code of ethics and auditing standards for the profession similar 
to those issued in the United Kingdom and the United States. 

The NIVRA has been actively involved in the legislative process 
related to accounting. For example, it welcomed the passage of the 
1970 act which specifies the series of examinations for an individual 
who wishes to become a registered accountant and to join the NIVRA. 

Accounting in the Netherlands is closely tied to business economics, 
a factor which has had a major effect on the development of account- 
ing standards in the country, and which is evident in the use of re- 
placement value by major corporations such as Philips N.V. The use 
of the replacement value concept is becoming widespread in the 
country since it is believed that the preparation of financial statements 
based on this concept helps the readers to make "a sound judgment" 
on the enterprise. Furthermore, the NIVRA fully supports the use of 
this concept for financial reporting purposes, which may also explain 
the reason for its popularity. 

FINANCIAL REGULATION IN SWITZERLAND 

Accounting in Switzerland is influenced by the Code of Obligations 
(Obligationenrecht) and the tax laws. According to the tax laws, for 
example, expenses cannot be deducted for tax purposes unless they 
have been recorded in the accounting books, a practice consistent with 
that in other continental European countries. In addition, uniform 
accounting systems have been gradually developed for different indus- 
tries in the country. These systems have proven to be flexible enough 
to accommodate the different needs of enterprises. Though voluntary, 
their use is fairly widespread, resulting in a formal standardization of 
accounting standards and procedures in Switzerland. 

Legal Requirements for Financial Reporting 

The influence of legislation on accounting is minimal. The only legis- 
lation available in Switzerland dealing with accounting and financial 



56 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



reporting is the Code of Obligations which has requirements so general 
that they can be interpreted on a very broad basis. Under this code, 
companies must keep accounting books, for example, in accordance 
with the "character and extent" of the business, showing the financial 
position and results of operations of the business (Article 957). Finan- 
cial statements should be prepared "completely, clearly and plainly in 
accordance with recognized commercial principles, so that interested 
parties may inform themselves as accurately as possible of the eco- 
nomic position of the business" (Article 959) . 

The Code of Obligations regulates the publicly held corporations 
(Aktiengesellschaft, abbreviated A.G.) and the privately held com- 
panies (Gesellschaft mit beschrankter Haftung, abbreviated GmbH). 
Each corporation is required to prepare a profit and loss statement 
and a balance sheet at the end of each accounting period. Only mini- 
mum disclosure is required in these statements and extreme conserva- 
tism is encouraged by the code (for example, formation and organi- 
zation costs are expensed and charged against the revenues of the 
period). In addition, requirements for the preparation of consolidated 
financial statements and statement of changes in financial position do 
not exist. 

A.G.s are required to have one or more statutory auditors (Kon- 
trollstelle) elected by the stockholders at the annual general meeting. 
Although no professional qualifications are required for this position, 
statutory auditors must be able to examine financial statements to be 
sure that they are prepared in accordance with the valuation standards 
set forth in the code and the company's bylaws. Furthermore, these 
auditors comment on the performance of management during the ac- 
counting period. If an A.G. has capital of SFrs. 5 million or more 
bonds outstanding, or has invited the public to entrust money to it, 
its financial statements must also be examined by an independent pro- 
fessional accountant appointed by the board of directors (Article 723). 
The report of this independent auditor should be submitted to the 
board of directors and the statutory auditors. 

The Accounting Profession 

The Code of Obligations does not require auditors to have any special 
expertise. In spite of this, auditing is normally performed by members 
of the Society of Swiss Certified Accountants (Verband Schweizerischer 
Bucherexpaten, abbreviated VSB) who are independent professional 
accountants mainly organized in corporations (fiduciary companies). 
To become a certified accountant, a person must pass preliminary and 



Regulation of Financial Accounting 57 



final examinations given by the Swiss Chamber of Fiduciary Auditors 
(Schweizerische Treuhand und Revisionskammer) and must meet 
specified experience requirements. 

The VSB is a division of the Swiss Chamber of Fiduciary Auditors. 
This chamber publishes nonbinding recommendations regarding ac- 
counting matters. It has also issued a code of ethics and a set of audit- 
ing standards that are expected to be followed by its members. Switzer- 
land enjoys full flexibility in regard to accounting standards and pro- 
cedures. 

Extreme conservatism prevails in Switzerland; only minimal dis- 
closure is required to protect outside interests and to ensure that no 
overstatements of assets occur. The prevailing continental European 
approach involving codified minimum accounting requirements also 
applies in Switzerland. Corporations which voluntarily exceed these 
requirements frequently follow an approach similar to that found in 
other German-speaking countries, such as the utilization of secret re- 
serves to protect creditors. 

FINANCIAL REGULATION IN THE UNITED KINGDOM 

Accounting regulation in the United Kingdom can be found in both 
professional pronouncements, "Statements of Standard Accounting 
Practice," and legislation, "Companies Acts." The former statements 
are prepared by the Institute of Chartered Accountants in England 
and Wales along with other major accounting bodies in the country 
and serve to supplement the requirements of the Companies Acts as 
to the form and content of financial statements. The provisions of 
these statements are mandatory on practicing accountants, and any 
departure from them is to be disclosed in the auditor's report. In 
addition, the Institute issues accounting standards to its members, 
"Recommendations on Accounting Principles," to guide them in prac- 
tice, and these recommendations are normally followed. 

Tax laws have little effect on accounting standards and procedures 
in the United Kingdom. In general, according to these laws, "generally 
accepted accounting standards" can be used as a base for determining 
the taxable income of a corporation. 

Legal Requirements for Financial Reporting 

At the present time, corporations are regulated by the Companies 
Acts of 1948 and 1967 which require all corporations to keep "proper 
books of account" containing the information necessary to give a "true 



58 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



and fair view" of the company's financial affairs. In addition, each 
corporation is required to prepare a profit and loss account and a 
balance sheet at the end of each accounting period. A company which 
has one subsidiary or more is generally required to prepare consoli- 
dated statements. 

Companies Acts mandate the appointment of a qualified auditor for 
each corporation. To qualify for appointment as auditors, individuals 
are considered for this role if they are members of one of the accounting 
bodies recognized by the Department of Trade for this purpose. In 
addition, a person may be authorized by the Department of Trade to 
be an auditor if it is decided that he has obtained similar qualifications 
outside the United Kingdom (for example, a certified public accoun- 
tant from the United States qualifies under this provision) . The audi- 
tors' report should state whether financial statements were prepared in 
conformity with the Companies Acts of 1948 and 1967 and whether 
they give a "true and fair view" of the company's financial position 
and results of operations. 

The Accounting Profession 

The accounting bodies whose members are qualified by the Department 
of Trade as auditors include (1) the Institute of Chartered Accoun- 
tants in England and Wales, (2) the Institute of Chartered Accoun- 
tants of Scotland, (3) the Institute of Chartered Accountants in Ire- 
land, and (4) the Association of Certified Accountants. These four 
bodies, in addition to the Institute of Cost and Management Accoun- 
tants, and the Chartered Institute of Public Finance and Accountancy, 
have formed joint committees to promote proper accounting standards 
(Accounting Standards Committee), to advance auditing practices 
(Auditing Practices Committee), and to present the views of the ac- 
counting profession (Consultative Committee of Accountancy Bodies). 

The Institute of Chartered Accountants in England and Wales 
issues "Recommendations on Accounting Principles" to guide its mem- 
bers in practice. Although departure from these recommendations does 
not necessarily require disclosure, these recommendations usually have 
been applied in practice. 

Accounting standards and procedures have been developed gradu- 
ally in the United Kingdom due to the cooperative efforts of both the 
government and the accounting profession. The latter is actively in- 
volved in the preparation of governmental legislation dealing with ac- 
counting matters. 



Regulation of Financial Accounting 59 



FINANCIAL REGULATION IN THE UNITED STATES 

In the United States, accounting is regulated by both the accounting 
profession and by legislation. The American Institute of Certified Pub- 
lic Accountants (AIGPA) and the Financial Accounting Standards 
Board (FASB) have been coordinating their efforts to regulate the 
practice of accounting in the country. This is done through the issu- 
ance of statements related to accounting and auditing standards that 
members of the AIGPA should observe in their accounting practices. 
The U.S. Uniform Commercial Code, on the other hand, does not 
contain any specific requirements for corporations to maintain account- 
ing books. However, state laws specify minimal record-keeping require- 
ments. In addition, the governmental Securities and Exchange Com- 
mission (SEC) has issued Regulation S-X and Accounting Series 
Releases specifying the form and content of financial statements of 
publicly held corporations. These statements include the income state- 
ment, the balance sheet, and the statement of changes in financial 
position. Finally, tax laws have had some effect on accounting practices 
in the country. 

Legal Requirements for Financial Reporting 

The SEC has tremendous legislative authority over the establishment 
of accounting standards and procedures in the United States. Under 
Section 19(a) of the Securities Act of 1933, the SEC can standardize 
accounting terminology, accounting measurement, and accounting re- 
porting. However, the SEC has been reluctant to exercise its power 
fully since it believes that the accounting profession should be allowed 
to police itself. The SEC requires that financial statements of publicly 
held corporations should be prepared in accordance with "generally 
accepted accounting principles" adopted by the accounting profession. 
Furthermore, the annual financial statements, with detailed supple- 
mentary schedules, filed with the SEC should accompany the auditor's 
report. 

The Accounting Profession 

Accounting flexibility has been the official attitude of the accounting 
profession in the United States, as measured by the actions of the 
American Institute of Certified Public Accountants and the Financial 
Accounting Standards Board. As early as 1932, a special committee of 
the AICPA in a report to the New York Stock Exchange took the 
following position: 



60 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



In considering ways of improving the existing situation two alternatives 
suggest themselves. The first is the selection by competent authority out of the 
body of acceptable methods in vogue today of detailed sets of rules which 
would become binding on all corporations of a given class. . . . The arguments 
against any attempt to apply this alternative to industrial corporations gen- 
erally are, however, overwhelming. 

The more practicable alternative would be to leave every corporation free 
to choose its own methods of accounting within the very broad limits to 
which reference has been made, but require disclosure of the methods em- 
ployed and consistency in their application from year to year. 1 

This laissez-faire approach undergirded the fifty-one Accounting 
Research Bulletins which were issued by the AICPA's Committee on 
Accounting Procedure (CAP) during the period 1939 to 1959. The 
1958 report of the Special Committee on Research Program of the 
AICPA emphasized the need "to narrow the areas of difference and 
inconsistency in practice." This report was an indictment of the prag- 
matic approach of the CAP and called for a new policy vehicle that 
would take a more theoretical approach, that is, the Accounting Prin- 
ciples Board (APB). 

The APB was established in 1959 to replace the CAP. This move 
signaled a change in the direction of the AICPA in its approach to 
developing accounting standards. In contrast to the CAP, the APB 
attempted to increase the use of the deductive approach in developing 
accounting standards. During the period from 1959 to 1973, the APB 
focused on specific problems and topics as did its predecessor and gen- 
erally appeared to be unwilling and unable to narrow the areas of 
difference and inconsistency in practice. The APB received continuing 
attack during this period from different segments of the society for its 
failure to cure accounting abuses. 

In 1971, the accounting profession responded by appointing a Study 
Group on Establishment of Accounting Principles (the Wheat Com- 
mittee) in order "to examine the organization and operation of the 
Accounting Principles Board and determine what changes are neces- 
sary to attain better results faster." As a result of the recommendations 
of the Wheat Committee, the Financial Accounting Standards Board 
was created and became fully operational in 1973. The conceptual 
framework under which it operates has been under consideration by 
the FASB for some time now. In the meantime, the FASB issues state- 
ments dealing with specific problems as was the case with the APB 
and CAP. 



1 American Institute of Accountants, Audits of Corporate Accounts (New York: 
AIA, 1934), p. 7. 



Regulation of Financial Accounting 61 



There have always been critics of accounting flexibility. While serv- 
ing as Chairman of the Securities and Exchange Commission, Carman 
Blough made this observation in 1937 : 

An examination of hundreds of statements filed with our Commission 
almost leads one to the conclusion that aside from simple rules of double entry 
bookkeeping, there are very few principles of accounting upon which the 
accountants in this country are in agreement. 2 

This may explain why the SEC played a major role in accounting 
regulation during the 1930s and 1940s through the issuance of its 
Accounting Series Releases. This role was necessary because of the 
abuses which existed during the 1920s and 1930s. Since the late 1940s, 
however, the SEC has allowed the accounting profession to undertake 
the formation of accounting standards. In recent years, a reaction to 
this has led to a movement toward greater accounting regulation. 

The SEC's reliance on the accounting profession to establish ac- 
counting standards and procedures may not continue because of the 
abuses and injustices in the accounting field. Recently, the accounting 
profession has been under attack from members of the Congress for 
failure to cure the abuses in the field. The SEC is presently under 
some pressure to exercise its power and to play a more active role in 
developing accounting regulation. 

In June 1978, Congressman John E. Moss, chairman of the U.S. 
House Subcommittee on Oversight and Investigation, introduced legis- 
lation to establish a National Organization of Securities and Exchange 
Commission Accountancy. This bill would require public accounting 
firms to register with such an organization and to furnish it with audit 
reports on the financial statements filed with the SEC. The proposed 
legislation also gives this organization the power to discipline those 
accounting firms and the principals in those firms not adhering to gen- 
erally accepted auditing standards. In addition, the organization will 
also 

Examine whether or not generally accepted accounting principles were 
applied with respect to the financial statements, reports, or other documents 
audited, particularly whether such accounting firms accept different account- 
ing principles on different engagements for like situations and whether such 
differentiation was justified. 3 

2 Carman G. Blough, "Need for Accounting Principles," Accounting Review 
(March 1937): 31. 

3 Deloitte Haskins & Sells, "Proposed Regulation of the Profession," The Week 
in Review (16 June 1978) : 2. 



62 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



This bill ultimately requires the SEC to 

Review all accounting principles, whether issued before or after the date of 
enactment of this Act, for purposes of determining if optimum uniformity has 
been achieved, and in cases in which such uniformity has not been achieved, 
develop and issue the needed accounting principles.* 

In an interview with the editor of Deloitte Haskins & Sells' The 
Week in Review on March 14, 1978, the chairman of the Financial 
Accounting Standards Board, Donald J. Kirk, stated that the FASB 
was striving to account for similar situations in a similar way and not 
to make dissimilar situations look alike. He further stated, "Compara- 
bility is high on our list of qualities that are needed for useful financial 
reporting and that will require a single method of accounting for 
similar situations." 5 Thus, it seems that the accounting profession is 
moving toward the adoption of an accounting model under which 
different accounting methods can be used for different economic facts 
under different circumstances. Each of these methods accurately re- 
flects the application of an accounting standard under a specified set 
of facts. 

CONCLUSION 

Accounting practices have been regulated throughout the world by the 
accounting profession in some countries, by legislation in others, and 
by both in still others. The status of the accounting profession in a 
country seems to play a major role in determining the party regulating 
accounting. For example, the low status and the relatively small size of 
the accounting profession in most nations of Asia, Africa, continental 
Europe, and Latin America have led to a situation in which accounting 
standards have been established by their individual governments. 

The main features of accounting in continental Europe, in general, 
seem to be conservatism, hidden reserves, legal reserves, and the im- 
portance of form over substance. In the Anglo-American countries, on 
the other hand, the emphasis is placed more on substance than on form. 
In actual practice, however, these countries appear to be slow in 
adopting those accounting standards which respond better to the needs 
of their societies. Accounting in Latin American countries and Japan, 
in general, follows the pattern found in continental European coun- 
tries, although a few of these countries have adopted more progressive 
accounting standards. 



4 Ibid., p. 3. 

5 Deloitte Haskins & Sells, "The Chairman Speaks," The Week in Review (17 
March 1978) : 1. 



A Comparison of Various International Proposals 
on Inflation Accounting: A Practitioner's View 

WILLIAM P. HAUWORTH II* 

INTRODUCTION 

Unfortunately, most countries now suffer from rampant inflation. 
This obviously has many adverse effects. It also has one effect that 
many consider beneficial. It has provided a stimulus for the account- 
ing profession in many countries, and the governments in a few coun- 
tries, to develop accounting systems that recognize effects of price 
changes. Some systems recognize effects of changes in the prices of 
specific items, some effects of changes in the general level of prices, 
and others effects of both types of changes. 

This paper summarizes and compares the methods to give an ac- 
counting recognition to the effects of changing prices that are now 
required or have been proposed in a number of countries throughout 
the world. 

PRICE-LEVEL ACCOUNTING 

The methods now used in the primary or basic financial statements in 
three countries — Argentina, Brazil, and Chile — are based on price- 
level or general purchasing-power or constant-dollar accounting. These 
methods, with certain exceptions, retain the historical cost basis of 
accounting and reflect effects of changes in the general level of prices. 

* William P. Hauworth II is a partner of Arthur Andersen & Co., Chicago. 
He has served as chairman of the International Practice Technical Standards 
Committee of the AICPA and is a member of that organization's Accountants 
International Study Group. 



64 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Argentina 

For a number of years, Argentina has had a high rate of inflation, 
frequently in three digits. As a result, the profession has actively pro- 
moted price-level accounting for some time. In 1971, a professional 
organization in Argentina published a recommendation advocating 
the presentation of price-level adjusted financial statements. A subse- 
quent professional pronouncement required financial statements for 
periods ending on or after September 30, 1976, to include price-level 
adjusted financial statements as supplementary information in a second 
column next to the unadjusted balances or in a note. 

In 1979, the Argentine accounting profession issued a further pro- 
nouncement that requires price-level adjusted financial statements to 
be presented as the primary financial statements for periods ending on 
or after September 30, 1979. To comply with legal requirements, un- 
adjusted statements, which reflect price-level or appraisal adjustments 
of property and depreciation accounts but not of other accounts, must 
be presented as supplemental information. Argentine auditors now 
express opinions on the price-level adjusted statements in terms of 
fairness in accordance with generally accepted accounting principles 
and on the unadjusted statements in terms of compliance with legal 
requirements. 

The price-level adjusted financial statements are required to reflect 
a comprehensive restatement that adjusts nonmonetary items for the 
change in the purchasing power of the peso from their date of origin 
to the balance-sheet date and presents the gain or loss in the purchasing 
power of net monetary items held during the period. Alternatively, a 
simplified approach can be used in restating certain nonmonetary 
items. Under this approach, 

1. Marketable securities are stated at market value at the balance- 
sheet date. 

2. Inventories are stated at current value. 

3. Property, and plant and equipment accounts are stated at the re- 
stated amounts determined for book purposes in accordance with 
Argentine law or at appraised amounts. 

4. Investments in business enterprises over which the investor exercises 
significant influence are stated at amounts determined by applying the 
equity method to the price-level adjusted financial statements of the 
investees. 

Companies not listed on the stock exchange or not subject to special 



Inflation Accounting 65 



government regulation can follow a simplified approach in their ad- 
justed income statements. Instead of restating individual items of in- 
come and expense and presenting the gain or loss from holding mone- 
tary items, they can present the effects of inflation in a single amount 
based on the change in restated net assets during the period. Any prior- 
period comparative financial statements presented are restated in terms 
of the purchasing power of the peso at the end of the current period. 

Brazil 

For some time, Brazilian legislation has required certain price-level 
adjustments to be reflected in financial statements. The method pres- 
ently used in calculating the adjustments is specified in the 1976 Cor- 
poration Law, which requires three adjustments to be made. 

The first restates permanent assets (which consist principally of 
property, plant and equipment, and long-term investments) and de- 
ferred charges based on the change during the year in a specified 
general price index. The second restates beginning net worth accounts 
based on the change in the same index. The third restates depreciation 
and amortization of permanent assets and deferred charges. The re- 
statement of permanent assets is credited, and the restatements of the 
net worth accounts and depreciation and amortization are charged to 
current income. 

These procedures are simple, and the results of applying them 
differ significantly from those obtained through comprehensive price- 
level adjustments only in that (1) inventory is treated as a monetary 
asset; and (2) no provision is made for updating prior-period financial 
statements. 

Chile 

For some years, Chilean law has required companies to restate their 
"invested capital" annually by applying the percentage increase in the 
consumer price index. The law also requires that property, and plant 
and equipment be restated in an amount equal to the lesser of ( 1 ) the 
amount by which invested capital is restated or (2) the amount de- 
termined by applying the percentage increase in the consumer price 
index to the property, and plant and equipment accounts. Depreciation 
is based on the restated amounts. If the restatement of invested capital 
exceeds the restatement of property, and plant and equipment, die 
excess or 20 percent of taxable income, whichever is less, must be 
charged to income. 



66 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



CURRENT-COST ACCOUNTING 

In a number of countries, the accounting profession has issued stan- 
dards, provisional standards, and exposure drafts dealing with the 
supplemental disclosure of current cost-accounting information. These 
countries include Australia, Canada, Germany, the Netherlands, New 
Zealand, South Africa, and the United Kingdom. 

Australia 

In Australia, the profession has issued a "provisional standard" that 
deals with "current-cost accounting" and "strongly recommends" that 
listed companies and public corporations include in their financial 
statements the following supplemental information on a current-cost 
basis: current cost of fixed assets and inventories, depreciation ex- 
pense, and cost of goods sold. 

The principal terms of the provisional standard are the following: 

1. Nonmonetary assets are to be stated at the lower of current cost 
(less accumulated depreciation, where applicable) and recoverable 
amount as of the balance-sheet date. In this regard 

a. Current cost is the lowest cost at which the asset's service poten- 
tial, when the asset was first acquired by the entity, could currently 
be obtained by the entity in the normal course of business. 

b. Recoverable amount is the amount expected to be recovered 
(i) from the total net cash revenues less all relevant cash expenses 
from the asset's continued use and/or (ii) through its sale. 

2. A restatement of the current cost of an asset is to be credited or 
charged directly to a special surplus account, which is referred to as the 
"current-cost adjustment account." 

3. Cost of goods sold is to be stated at the current cost of the goods at 
the time of sale or, if the goods had previously been written down to 
their recoverable amount, at that amount. 

4. Depreciation is to be reported based on the average-for-the-period 
of the assets' current cost or, for assets carried at recoverable amounts, 
on the basis of that amount. 

The Australian profession has issued two exposure drafts dealing 
with monetary items in the context of current-cost accounting. The 
latest provides for reporting "profit and gearing gains attributable to 
shareholders" and "entity net profits." The former reflects gains and 
losses in the purchasing power of all monetary items as well as adjust- 
ments to state depreciation and cost of sales at current cost. The latter 
reverses the gain or loss in the purchasing power of "loan capital." 



Inflation Accounting 67 



The exposure draft provides for computing the purchasing-power 
gains and losses by : 

1. Applying to trade receivables and trade payables the percentage 
change during the period in the current cost of the inputs of goods 
and services that are principally responsible for the balances of trade 
payables and the products whose sales generate the trade receivables. 

2. Applying the percentage change during the year in the general 
price level to the monetary items of an enterprise whose business is the 
lending of money. 

3. Applying to loan capital the percentage change in the general price 
level. 

4. Applying to other monetary assets and liabilities the percentage 
change in a price-index representative of inputs of goods and services 
during the period or, if this is impracticable, in a general price index. 

The gain or loss in the purchasing power of all monetary assets and 
liabilities is to be credited or charged to income with an offsetting en- 
try to the current-cost adjustment account. Below the caption "profit 
and gearing gains attributable to shareholders," the gain or loss in the 
purchasing power of loan capital is to be reversed and taken to a 
"gearing gains reserve account" included in shareholders' equity. The 
final caption in the income statement, "entity net profits," excludes 
the gain or loss on loan capital. 

In March 1980, the Australian profession issued a further exposure 
draft that deals with the extention of current-cost accounting to non- 
monetary items in addition to inventories and property. Its provisions 
are generally consistent with those of the provisional standard. 

Canada 

The Canadian Institute of Chartered Accountants issued a discussion 
paper on current-value accounting in 1976 and, after considering the 
responses to that paper, issued an exposure draft entitled "Current 
Cost Accounting" in December 1979. The draft proposes requiring 
certain enterprises to present supplementary current-cost information 
together with their annual historical cost financial statements. The 
enterprises affected are those whose securities are publicly traded and 
that have either ( 1 ) inventories and property, and plant and equip- 
ment (before deducting accumulated depreciation, depletion, and 
amortization) totalling at least $50 million or; (2) total assets of at 
least $350 million. 



68 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



An enterprise presenting supplementary current-cost information is 
to present "current cost income of the enterprise" and "current cost 
income attributable to shareholders." 

The "current cost income of the enterprise" is intended to present 
income after providing for the impact of specific price changes on the 
productive assets needed to maintain the enterprise's operating capa- 
bility, whether they are financed by equity capital or debt. It is to be 
determined by making the following adjustments to historical cost 
income before deducting interest expense and income taxes. 

1. A depreciation adjustment, representing the difference between 
depreciation for the period calculated on the current cost of property, 
plant and equipment, and the depreciation charged in the historical 
cost financial statements; 

2. A cost of sales adjustment, representing the difference between the 
current cost, at the date of sale of goods sold during the period and 
the cost of goods sold charged in the historical cost financial state- 
ments; 

3. A net-productive monetary-items adjustment to provide for the 
effect of specific price changes during the period on the net-produc- 
tive monetary items required to support the operating capability of 
the enterprise; and 

4. Any other material adjustments required to allow for the impact of 
specific price changes on the productive assets of the enterprise, for 
example, adjustments relating to disposals of items of property, and 
plant and equipment during the period. 

The exposure draft defines current cost as the amount of cash or 
other consideration, measured in units of money, that would be needed 
to acquire an asset identical or equivalent to that owned. Acquisition 
might be either by purchase or production, as appropriate in the cir- 
cumstances of the enterprise. The use of current cost as a measure- 
ment of an asset owned by an enterprise is subject to the restriction 
that: 

1. In the case of assets held for sale, the measurement of the asset 
should not exceed net realizable value; and 

2. In the case of assets held for use in the enterprise, the measure- 
ment of the asset should not exceed value in use, which is the net 
present value of future cash flows expected to result from the use of 
an asset in the enterprise and from its ultimate disposition. 



Inflation Accounting 69 



The net productive monetary items with respect to which an ad- 
justment is to be made are (1) short-term trade receivables, accruals, 
and prepaid expenses; (2) inventories not subject to a cost of sales 
adjustment; and (3) cash balances required for the conduct of day-to- 
day operating activities; net of (a) short-term trade payables and 
accruals; and (b) short-term loans required for the conduct of day-to- 
day operating activities. 

The exposure draft states that calculation of the adjustment re- 
quires that relevant rates of price change be identified for each com- 
ponent of net productive monetary items. For example, the adjust- 
ment relating to receivables is to reflect changes in the current cost 
of goods or services sold that are attributable to changes in prices of 
the materials, labor, and other inputs, used to produce the goods. In 
many instances, changes in selling prices may provide an appropriate 
guide. Where payables are concerned, the adjustment is to reflect 
changes in the current cost of items that have been financed by those 
payables. 

In addition to "current cost income of the enterprise," the supple- 
mentary information is to present "current cost income attributable to 
shareholders." This is intended to reflect the costs and benefits to the 
shareholders of financing a portion of the enterprise's productive assets 
with borrowed funds. It is determined by adjusting current-cost income 
of the enterprise to provide for income taxes and, when the productive 
assets of the enterprise are partly financed by net borrowings, to reflect 
the interest cost of debt, dividends on nonparticipating preferred shares, 
and a financing adjustment. 

The financing adjustment is to reflect the realized cost or benefit 
to shareholders of financing productive assets with net borrowings. It 
is calculated by (1) determining the ratio of net borrowings to the 
sum of net borrowings and shareholders' equity, and (2) applying this 
ratio to the total of the current-cost adjustments reflected in the com- 
putation of current-cost income of the enterprise. 

The exposure draft states that per share data should be presented 
for current-cost income attributable to the shareholders. 

In addition to the income statement data, the supplementary infor- 
mation is to disclose the carrying value of inventory and property, 
and plant and equipment on a current-cost basis, compared with the 
corresponding net book amounts reported in the historical cost finan- 
cial statements. 

The exposure draft also provides for the presentation of a state- 



70 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



merit of changes in shareholders' equity giving effect to the restate- 
ment of inventory and property, and plant and equipment on a current- 
cost basis. The statement is to disclose separately the following items : 

1. The change in the amount required to maintain the operating 
capability of the enterprise, distinguishing amounts attributable to: 

a. An increase/decrease in the current cost of property, and plant 
and equipment during the period ; 

b. An increase/decrease in the current cost of inventory during the 
period; and 

c. An increase/decrease in net productive monetary items due to 
specific price changes during the period; 

2. The amount of the financing adjustment; and 

3. Current-cost income for the period attributable to shareholders. 

Germany 

In 1975, the German profession issued a pronouncement recommend- 
ing that certain supplementary replacement-cost information be pre- 
sented in a note to annual financial statements. The information re- 
lates to assets financed by equity, and the pronouncement is based on 
the assumption that equity is used first to finance property, and plant 
and equipment, then to finance inventories, and finally to finance 
other assets. The information to be disclosed is (1) the excess of re- 
placement cost over historical cost depreciation, and (2) the amount 
required to maintain the operating capacity of inventory. 

If the amount of equity is less than the amount of property, and 
plant and equipment, the excess of replacement cost over historical 
cost depreciation to be reported is the total excess multiplied by the 
ratio of equity to property, and plant and equipment. In that event, 
no amount is reported with respect to inventory. 

If the amount of equity exceeds the amount of property, and plant 
and equipment, the amount required to maintain the operating capacity 
of inventory is determined by applying the percentage-price increase 
during the year relating to items included in ending inventory to the 
amount of the beginning inventory. If the ratio of (1) equity less 
property, and plant and equipment to (2) inventory is less than 1.0, 
this ratio is applied to the amount determined by applying the per- 
centage price increase, and the result is the amount to be disclosed. 

The German government is opposed to the presentation of account- 
ing information that recognizes effects of price changes on the basis 
that presenting the information may increase inflation. Thus, the 



Inflation Accounting 71 



government has not supported the profession's recommendation, and 
relatively few companies have applied it. 

The Netherlands 

In the Netherlands, a commission composed of representatives from 
industry, the trade unions, and the accounting profession issues pro- 
nouncements on accounting matters. It has issued a recommendation 
that states that information that is more meaningful than historical 
cost is required with respect to property, and plant and equipment 
that has been held for a considerable length of time. The recommenda- 
tion also states that more meaningful information can be provided 
either by revaluing the assets to current values or by disclosing current- 
value information in a note. 

Leaders in the accounting profession generally recommend that 
assets, particularly depreciable fixed assets, be accounted for on the 
basis of replacement cost or appraised values, and a significant num- 
ber of companies have adopted this basis of accounting for property, 
and plant and equipment. 

A credit arising from a restatement of assets is generally reported 
in a separate reserve in the capital stock and surplus section of the 
balance sheet. Because the excess of depreciation based on replace- 
ment cost over depreciation based on original cost is not deductible 
for tax purposes, the reserve for revaluation is often recorded on a 
net-of-tax basis. A number of companies that state their property ac- 
counts at replacement cost also state their inventories on this basis. 

New Zealand 

In New Zealand, the accounting profession has issued a pronouncement 
that requires all listed companies to present a supplemental balance 
sheet and profit and loss account on a current-cost basis. 

In the supplemental balance sheet, all nonmonetary assets are to 
be stated at their value to the business. The pronouncement states 
that the value to the business of an asset whose loss would materially 
impair the operating capability of the business is replacement cost less, 
where applicable, depreciation. The value to the business of an asset 
whose loss would not materially impair its operating capability is net 
realizable value. 

The supplemental profit and loss account presents two measures of 
profitability: the "current cost operating profit of the enterprise" and 
the "profit attributable to the owners." 



72 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



In arriving at the "current cost operating profit of the enterprise," 
the following principles are to be applied. 

1. Depreciation is based on the current replacement cost of the related 
assets; 

2. Cost of sales is based on the current cost of inventory at the time it 
is sold or consumed; 

3. An adjustment is made to reflect the change in the purchasing 
power of "circulating monetary assets" ; and 

4. Interest on borrowed funds is not taken into consideration. 

The circulating monetary assets of an enterprise are those mone- 
tary assets that must be maintained in order to service the production 
and selling activities in which the enterprise is engaged. These include 
cash (including deposits for a fixed term of up to twelve months), 
trade accounts receivable, installment receivables, notes receivable, 
refundable deposits paid, and contract work in process under fixed 
price contracts. 

The adjustment to reflect the change in the purchasing power of 
circulating monetary assets is computed by multiplying the period's 
average investment in circulating monetary assets by the period's 
change in the general price index for the country. 

The "profit attributable to the owners" is calculated by adjusting 
the "current cost operating profit of the enterprise" for the following 
items: (1) interest on borrowed funds; (2) the change in the value 
of those nonmonetary assets financed by borrowings; and (3) the 
change in the purchasing power of those circulating monetary assets 
financed by borrowing. 

The change in the value of those nonmonetary assets financed by 
borrowings is calculated by multiplying the amount by which non- 
monetary assets were revalued during the period by the ratio of average 
borrowings to average total assets during the period. Likewise, the 
change in the purchasing power of those circulating monetary assets 
that are financed by borrowings is calculated by multiplying the ad- 
justment to reflect the change in the purchasing power of circulating 
monetary assets during the period by the ratio of average borrowings 
to average total assets during the period. 

South Africa 

In 1978, the profession in South .Africa issued a guideline advocating 
the presentation of a supplemental current-cost income statement in 
which (1) depreciation is based on the current value to the business 



Inflation Accounting 73 



of its depreciable assets; (2) cost of sales is based on current value to 
the business of inventory on the date of sale; (3) a gain or loss on 
the disposition of a depreciable asset is based on its depreciated current 
cost; and (4) a gearing adjustment is reported. 

The guideline states that the value to the business of a depreciable 
asset is the current cost that would have to be incurred to obtain and 
install an equivalent asset unless the asset will not be replaced upon 
the expiration of its useful life or it is no longer being used. If an 
asset will not be replaced, its value to the business is the higher of its 
recoverable amount and net realizable value; if an asset is no longer 
being used, its value to the business is net realizable value. The value 
to the business of inventory is the lower of current-cost and net realiz- 
able value. 

If monetary assets exceed monetary liabilities, the gearing adjust- 
ment is computed by multiplying the average net monetary asset posi- 
tion by an index representative of the change in the price of the com- 
pany's inputs. 

If monetary liabilities exceed monetary assets, the gearing adjust- 
ment is computed by multiplying the sum of the difference between 
depreciation, cost of sales, and gains and losses on the disposition of 
depreciable assets on a current-cost basis and those amounts on the 
historical cost basis by the ratio of net monetary liabilities to the sum 
of net monetary liabilities, equity, deferred tax balances, and notes 
payable convertible into shares. 

United Kingdom 

More time has probably been spent on developing a system of inflation 
accounting in the United Kingdom than in any other country. In Jan- 
uary 1973, the profession issued its first exposure draft on the subject, 
which proposed a system of general purchasing-power accounting. Fol- 
lowing the publication of the Sandilands Report in 1975, the U.K. 
profession switched to current-cost accounting and issued a standard 
on the subject in March 1980, which is effective for years beginning 
after December 31, 1979. 

The current-cost accounting standard applies to entities whose se- 
curities are listed on The Stock Exchange and to other entities that 
meet a size test. However, certain entities, including insurance com- 
panies and property investment companies, are exempted. 

Affected enterprises are required to present a current-cost profit 
and loss account and balance sheet. This requirement can be complied 
with in any of three ways : 



74 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



1. By presenting historical cost financial statements as the primary- 
statements and supplementary current-cost statements; 

2. By presenting current-cost financial statements as the primary state- 
ments and supplementary historical cost statements ; or 

3. By presenting current-cost financial statements as the only state- 
ments accompanied by adequate historical cost information. 

The concept of value underlying the standard is value to the busi- 
ness which ordinarily is the net current cost of a replacement asset 
that has a similar useful output or service capacity as that of the 
existing asset when it was acquired. However, if a permanent diminu- 
tion to a lower value has been recognized, the value to the business of 
an asset is the greater of its net realizable value and, if applicable, the 
amount recoverable from its further use. 

The current-cost profit and loss account is to present two measures 
of profitability: the "current-cost operating profit" and the "current- 
cost profit attributable to the shareholders." The "current-cost operat- 
ing profit" is stated before interest on net borrowings and income taxes 
and is to reflect three adjustments to the amounts reported on the 
historical cost basis. 

1. The first adjusts depreciation to reflect the value to the business 
of depreciable assets consumed during the period. 

2. The second adjusts cost of sales to the value to the business of in- 
ventory sold or consumed during the period. 

3. The third is a monetary working capital adjustment. 

Monetary working capital is defined as the aggregate of trade ac- 
counts and notes receivable, prepayments, and inventories not subject 
to the cost of sales adjustment less trade accounts and notes payable 
and accruals. That part of bank balances or overdrafts that fluctuates 
with the volume of these items as well as any cash floats required to 
support day-to-day operations of the business are to be included in 
monetary working capital if the effect of their inclusion on the "cur- 
rent-cost operating profit" is material. 

The monetary working capital adjustment is to be computed by 
applying to each element of the monetary working capital the change 
in a relevant price index. The index for receivables should reflect the 
current cost of input costs applicable to the goods and services sold. 
The index for payables should reflect the cost of items financed by the 
payables. 

"Current-cost profit attributable to shareholders" is determined 



Inflation Accounting 75 



after interest, income taxes, extraordinary items, and a gearing ad- 
justment. The gearing adjustment is determined by multiplying the 
aggregate of the three adjustments reflected in "current-cost operating 
profit" by the ratio of net borrowings to net operating assets. Net bor- 
rowings are defined as the excess of : 

the aggregate of all liabilities and provisions fixed in monetary terms 
(including convertible debentures and deferred tax but excluding pro- 
posed dividends) other than those included within monetary working 
capital and other than those that are, in substance, equity capital 
over 

the aggregate of all current assets other than those subject to a cost of 
sales adjustment and those included within monetary working capital. 

Listed companies are required to disclose earnings per share based 
on the current-cost profit attributable to equity shareholders. 

In the current-cost balance sheet, the following principles should 
be applied. 

1. Property, and plant and equipment, and inventories are to be stated 
at their value to the business. 

2. Investments to which the equity method applies are to be stated at 
equity in net assets stated on the current-cost basis or at the directors' 
best estimate thereof. 

3. Other investments are to be stated at the directors' valuation. 

4. Intangible assets other than goodwill are to be stated at the best 
estimate of their value to the business. 

5. Goodwill is to be stated at the amount reported on the historical 
cost basis less any amount included therein that represents an excess 
of the value to the business over the historical cost of identifiable 
assets held by a subsidiary at the date of its acquisition. 

6. Current assets not subject to the cost of sales adjustment and all 
liabilities are to be stated on the historical cost basis. 

HYBRID METHODS 

What might be referred to as hybrid methods of accounting for effects 
of price changes, because they combine features of both price-level 
and current-cost accounting, are now in effect in Mexico and the 
United States. 

Mexico 

The profession in Mexico issued an exposure draft on inflation account- 



76 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ing in November 1978 and a final statement in February 1980. This 
statement applies to all enterprises other than financial institutions, 
insurance companies, and not-for-profit entities. It is effective for 
years beginning after December 31, 1979. 

The statement provides for the annual restatements of inventories; 
property, and plant and equipment; cost of sales; and depreciation 
expense. These restatements may be based on either current specific 
prices or the change in the consumer price index. If specific prices are 
used, they ordinarily are to be based on the replacement cost of inven- 
tory items and appraisals of property, and plant and equipment. 

The statement permits the restatement of property, plant and 
equipment, and depreciation either to be recorded in the books and 
reflected in the basic financial statements or to be disclosed in a note 
or appendix to the statements. The restatement of inventories and 
cost of sales is to be disclosed in a note or appendix to the statements. 

A statement of price-level adjusted shareholders' equity is to be 
included in the note or appendix. This is to report income for the 
period after the depreciation and cost of sales adjustments and the 
gain or loss during the period in the purchasing power of net mone- 
tary items. 

Those companies using specific prices to restate nonmonetary assets 
are to compare the amount of the restatement with the amount com- 
puted by applying the change in the consumer price index to the non- 
monetary assets. The difference is to be reported in the statement of 
price-level adjusted shareholders' equity as the gain or loss from hold- 
ing nonmonetary assets. 

United States 

Inflation accounting has been discussed in the United States for at 
least thirty years. Finally, on December 25, 1979, the effective date of 
Statement of Financial Accounting Standards No. 33, inflation ac- 
counting became part of the reporting requirements applicable to cer- 
tain large, publicly held companies. 

These companies must disclose certain effects of changing prices 
as supplementary information to their basic financial statements. SFAS 
No. 33 requires each affected enterprise to report, for fiscal periods 
ending after December 25, 1979, income from continuing operations 
adjusted for changes in the general price level (that is, on the histori- 
cal cost/constant dollar basis) and the purchasing-power gain (or loss) 
on net monetary items. The statement also requires disclosure of in- 



Inflation Accounting 77 



come from continuing operations measured using the current cost of 
inventories and property, plant and equipment, and the net increases 
(decreases) in the current costs of inventories and property, plant and 
equipment, and the amount of that increase (decrease) due to changes 
in the general price level. However, these current-cost amounts do not 
have to be reported until 1980 reports are issued. 

Each affected company also must report a five-year summary of 
the following information stated in either the average of current-year 
constant dollars or dollars of the base year for the Consumer Price 
Index for All Urban Consumers. 

1. Net sales and other operating revenues; 

2. Income, including per share amounts, from continuing operations 
calculated on both historical cost/constant dollar and current-cost 
bases; 

3. Purchasing-power gain or loss on net monetary items; 

4. Net assets at fiscal year end at both current-cost and historical 
cost/constant dollar amounts; 

5. Net increases (decreases) in the current-cost amounts of inventory 
and property, and plant and equipment, net of general price inflation; 

6. Cash dividends per common share; and 

7. Market price per common share at year end. 

These disclosure requirements apply to public companies that have 
either ( 1 ) inventories and property, and plant and equipment before 
deducting accumulated depreciation, depletion, and amortization of 
more than $125 million, or (2) total assets net of accumulated depre- 
ciation, depletion, and amortization of more than $1 billion. 

SFAS No. 33 imposes a limit on the amount at which assets are to 
be stated on both the historical cost/constant dollar and the current- 
cost bases. Amounts reported on these bases are not to exceed the 
assets' "recoverable amount," defined as the current worth of the net 
amount of cash expected to be recoverable from the use or sale of the 
assets. The statement provides that recoverable amounts may be taken 
to be net realizable value in the case of an asset that is about to be 
sold and value in use in the case of other assets. Value in use is the 
net present value of future cash flows (including the ultimate proceeds 
of disposal) expected to be derived from the use of an asset by the 
enterprise. "Recoverable amount" is calculated for asset groups (except 
in the case of an asset used independently of other assets) and need 
not be calculated unless it is judged to be materially and permanently 



78 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



below historical cost/constant dollars or current cost. If used, recover- 
able amount replaces historical cost/constant dollars and/or current 
cost in calculating the supplemental disclosures. 

SFAS No. 33 does not require a comprehensive adjustment of all 
financial statement items to compute either historical cost/constant 
dollar or current-cost income from continuing operations although 
comprehensive restatement is permitted. SFAS No. 33 requires only 
cost of goods sold and depreciation, depletion, and amortization to be 
adjusted. Revenues, other operating expenses, and income taxes are 
assumed to be stated in amounts that are not materially different from 
current cost and constant dollars. 

SFAS No. 33 differs significantly from the pronouncements issued 
in other countries in that it does not come to a bottom line. The pur- 
chasing-power gain or loss on net monetary items, the amount of the 
increase/decrease in the current costs of inventories and property, 
plant and equipment, and income from continuing operations are not 
required to be totalled. 

INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE 

The International Accounting Standards Committee has taken an 
active interest in accounting for changing prices. In June 1977, it 
issued International Accounting Standard No. 6 which states: 

In complying with International Accounting Standard 1, Disclosure of Ac- 
counting Policies, enterprises should present in their financial statements in- 
formation that describes the procedures adopted to reflect the impact on the 
financial statements of specific price changes, changes in the general level of 
prices, or of both. If no such procedures have been adopted that fact should 
be disclosed. 

At its March 1980 meeting, the IASC approved the publication of 
an exposure draft of a possible replacement of International Account- 
ing Standard No. 6. When published, this exposure draft will state that 
large enterprises whose securities are publicly traded should present 
supplementary information that adjusts cost of sales and depreciation 
for the effect of changing prices. It will leave the door open to the 
presentation of a financing or gearing adjustment. 

COMPARISON OF METHODS 

The methods of accounting for price changes that are presently in 
effect or being considered in twelve countries have now been reviewed. 
In what respects are these various methods similar? How do they 



Inflation Accounting 79 



differ? Focusing on a few key factors will facilitate a comparison of 
the various methods. These factors are listed below. 

1. Is inflation accounting incorporated into the primary financial state- 
ments or presented as supplementary information? 

2. What companies are to report inflation accounting information? 

3. How are inventories, property, and plant and equipment stated? 

4. What balance-sheet information is presented? 

5. What concept of capital maintenance is implied? 

Location of Information 

It is interesting to note that in the three countries — Argentina, Brazil, 
and Chile — in which some variation of historical cost/constant dollar 
accounting is applied, inflation accounting is incorporated into the 
primary financial statements. On the other hand, in the countries using 
a current-cost or hybrid method, inflation accounting is presented as 
supplementary information, except in Mexico where it may be par- 
tially reported in the primary statements and in the Netherlands and 
the United Kingdom where it may be reported either in the primary 
statements or as supplementary information. Several years ago, the 
professions in Australia and the United Kingdom had contemplated 
a mandatory early incorporation of current-cost accounting into pri- 
mary financial statements. This proved not to be feasible. It is also 
interesting that, of the countries reviewed, the three with the highest 
inflation rates are those using some variation of historical cost/constant 
dollar accounting. 

One may conclude that with extreme inflation, historical cost/nom- 
inal dollar accounting becomes meaningless and price-level adjustments 
must be incorporated into the primary financial statements. However, 
because of resistance to change, a considerable period of time will be 
needed before current-cost accounting is likely to be required to be 
incorporated into primary financial statements. 

Applicability of Requirements 

In the countries in which some variation of historical cost/constant 
dollar accounting is used, all enterprises must follow the prescribed 
method. In the three current-cost countries in which compliance with 
the profession's suggestion regarding current-cost accounting is not 
mandatory — Germany, the Netherlands, and South Africa — those 
suggestions apply to all enterprises. In the other countries, the relevant 
pronouncements apply to only certain enterprises, such as large com- 



80 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



parries with publicly traded securities, or all listed companies, or all 
listed and certain other companies. 

The limitations on the applicability of the relevant pronouncements 
presumably are based on cost/ benefit considerations. The countries in 
which applicability is limited are countries in which the required in- 
formation is or may be presented as supplementary information. It 
would not be logical to limit a requirement to incorporate current- 
cost accounting into primary financial statements to only some com- 
panies. Thus, cost benefit considerations are likely to impede the in- 
corporation of current-cost accounting into primary statements. 

Valuation of Inventories and Property, and Plant and Equipment 

Considerable variety exists with respect to the valuation of inventories, 
property, and plant and equipment in the three countries in which 
some variation of historical cost constant dollar accounting is applied. 
In Argentina, both are stated at historical cost expressed in pesos of 
current purchasing power. In Brazil, property, and plant and equip- 
ment are stated on this basis while inventors- is stated at historical cost 
in nominal cruzeiros. In Chile, property, and plant and equipment (to 
die extent they do not exceed equity) are stated at historical cost ex- 
pressed in escudos of current purchasing power, while other property 
and inventories are stated at historical cost in nominal escudos. 

There is more similarity with respect to the valuation of inventories 
and property, and plant and equipment among the various methods of 
current-cost accounting. The methods all focus on the current repro- 
duction cost of existing assets. Most also provide for using some mea- 
sure of recoverable amount when it is less than current cost. One 
difference in this regard is that when the recoverable amount is based 
on the future cash flows from the use and eventual disposition of an 
asset, the cash flows are to be discounted to their present value in 
Canada and the United States, but not in Australia, South Africa, or 
the United Kingdom. Particularly in view of today's interest rates, 
discounting appears to be required to produce meaningful amounts. 

Balance-Sheet Information 

In general, greater attention has been given to income-statement than 
to balance-sheet effects of price changes. Full balance sheets in which 
at least some assets are stated at amounts that reflect effects of price 
changes are provided for in the three countries using a system of 
historical cost/constant dollar accounting and in the Netherlands, New 
Zealand, and the United Kingdom. Disclosure of the current cost of 



Inflation Accounting 81 



property, plant and equipment, and inventories is provided for in 
Australia, Canada, Mexico, and the United States. The pronounce- 
ments in Germany and South Africa do not mention balance-sheet 
data. 

Just as presentations of the results of operations that reflect effects 
of price changes often differ significantly from, those that do not, pre- 
sentations of financial position that reflect effects of price changes often 
differ significantly from those that do not. Restated balance sheets as 
well as restated income statements are needed to inform users of the 
statements of the impact of price changes on a business entity. 

Capital Maintenance 

The aspect of accounting for price changes that has been the most 
controversial has been which concept of capital maintenance to use 
and the related treatment of monetary items. 

The concept underlying the systems of historical cost/constant dollar 
accounting being applied in Argentina, Brazil, and Chile is financial 
capital measured in units of constant purchasing power. That concept 
is consistent with the disclosures required in Mexico and by SFAS No. 
33 in the United States. However, the FASB has avoided taking a 
position on the capital maintenance issue by not including a "bottom 
line" as part of its disclosures. 

The concept of capital maintenance underlying the current-cost 
accounting systems in other countries is physical capital or operating 
capacity. However, considerable variations exist among countries on 
how this concept is applied : 

1. In the Netherlands, the physical capital of an entity appears to be 
considered to be its property, and plant and equipment plus, perhaps, 
its inventory, regardless of how those assets are financed. 

2. In Germany, the physical capital of an entity appears to be its prop- 
erty, plant and equipment, and inventory financed by equity; mone- 
tary items — including any financed by equity — are ignored. 

3. In South Africa, the operating capacity of an entity appears to be 
its property, plant and equipment, and inventory financed by equity 
plus the purchasing power of any net monetary asset position financed 
by equity. 

4. In Australia, Canada, New Zealand, and the United Kingdom, two 
measures of profitability are to be disclosed. The concept of capital 
to be maintained for the purpose of computing an entity's operating 
profit is the aggregate of the physical assets included in property, plant 



82 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



and equipment, and inventories plus the purchasing power of circu- 
lating monetary assets or of net monetary working capital, regardless 
of how they are financed. Income attributable to the shareholders 
then reflects a gearing gain. In Australia, the gearing gain equals the 
decline in the purchasing power of loan capital. In New Zealand, it 
equals the increase in the value of nonmonetary assets financed by bor- 
rowings. In Canada and the United Kingdom, it equals the proportion 
of the current-cost adjustments for depreciation, cost of sales, and 
monetary working capital applicable to items financed by borrowings. 

This author believes that the standard setters need to reconsider 
their conclusions regarding capital maintenance. Many of the existing 
pronouncements do not clearly articulate the concept to be applied but 
rather concentrate on explaining the mechanics of computing adjust- 
ments for gearing gains. 

CONCLUSION 

In most countries in which they exist, accounting systems that recog- 
nize effects of price changes have just recently been or are yet to be 
implemented. Thus, users of financial statements have yet to assess 
the utility of the information provided by these systems. A clear pic- 
ture of the future of inflation accounting will become apparent only 
after users obtain experience with this information. Nevertheless, this 
author expects that the information will prove to be worthwhile and, 
unless inflation abates, will become a progressively more important 
part of financial reporting. 



Primary-Secondary Reporting: A Cross-Cultural 
Analysis 

FREDERICK D. S. CHOI* 



Financial managers of multinational enterprises have been innovative 
in tapping the savings of transnational investor groups. 1 In addition to 
selling debt and equity securities in both national and international 
capital markets, many companies have listed their shares on foreign 
stock exchanges as a prelude to future financing. The international 
distribution of corporate securities has, in turn, confronted both finan- 
cial managers and accountants alike with reporting problems of no 
small proportion. For one thing, foreign readers reside and operate in 
socioeconomic environments which differ from that of the reporting 
company. Accordingly, standards of comparison and choice criteria 
may vary from country to country. Foreign readers are also accustomed 
to analyzing and interpreting financial statements in the context of 
their own national set of accounting and reporting norms. Under 
these circumstances, the challenge of transnational financial reporting 
lies in "conveying to a foreign reader the same message as would be 
received by a domestic reader." 2 

* Frederick D. S. Choi is professor of accounting and finance at the University 
of Hawaii. He is currently visiting professor of accounting and international 
business at New York University. He is chairman of the Pacific Basin Region of 
the Academy of International Business. 

1 For example, see A. Middernacht, "The Development of Euromarket Borrowing 
Instruments," Euromoney (April 1975) : 42. 

* Gerhard G. Mueller and Lauren M. Walker, "The Coming Age of Trans- 
national Financial Reporting," Journal of Accountancy (July 1978) ; reprinted 
in Frederick D. S. Choi and Gerhard G. Mueller, Essentials of Multinational 
Accounting: An Anthology (Ann Arbor, Mich.: University Microfilms Inter- 
national, 1979), p. 82. 



84 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



This paper examines a proposed reporting framework that is cur- 
rently being courted as the optimal solution to the transnational re- 
porting problem. The proposal in question was originally advocated by 
the Accountants International Study Group (AISG) and recommends 
that multiple sets of statements, primary and secondary, be prepared 
for a firm with audiences of interest in more than one country. 3 The 
evidence presented here suggests that, contrary to the proposal's ori- 
ginal intent, primary-secondary reporting has the potential to mislead 
rather than improve the communication of financial information to 
foreign audiences of interest. 

COMMUNICATION — AN INTEGRAL FEATURE OF THE ACCOUNTING PROCESS 

Accounting may be broadly defined as a measurement and communi- 
cation process. Bedford conceptualizes this process as consisting of four 
procedural steps 4 : 

1. Perception of the significant activity of the accounting entity or in 
the environment in which the entity performs. Implicit in the tradi- 
tional perception is the belief that financial transactions represent the 
significant activities. 

2. Symbolizing the perceived activities in such a fashion that a data 
base of the activities is available that can then be analyzed to grasp 
an understanding of the interrelationships of the mass of perceived 
activities. Conventionally, this symbolization has taken the form of 
recordings in accounts, journals, and ledgers using well-established 
bookkeeping and measurement procedures. 

3. Analysis of the model of activities in order to summarize, organize, 
and lay bare the interrelationships among activities and to provide a 
status picture or map of the entity. Traditionally, this analysis process 
has been viewed as one of developing accounting reports to provide in- 
sights into the nature of entity activities. 

4. Communication (transmission) of the analysis to users of the ac- 
counting product to guide decision makers in directing future activities 
of the entity or in changing their relationship with the entity. 

This operational conception views accounting information as sym- 
bolic representations of entity related activities. Thus, in examining 

3 Accountants International Study Group, "International Financial Reporting," 
Study No. 11 (Toronto, Canada: AISG, 1975). 

* Norton M. Bedford, Extensions in Accounting Disclosure (Englewood Cliffs, 
N.J.: Prentice-Hall, Inc., 1973), p. 5. 



Primary-Secondary Reporting 85 



the outputs of the accounting process from the perspective of the for- 
eign reader, we must examine (1) the adequacy of the scope of ac- 
counting perceptions, (2) the efficiency of the symbolization process, 
(3) the extent of available analytical constraints, and (4) the effec- 
tiveness of the communication. This paper concentrates on the latter. 

Since accounting information relies heavily on symbolic representa- 
tion of enterprise activities, effective communication of these activities 
abroad requires that the message sender (accountant) and the message 
receiver (foreign reader) have a common understanding of the mean- 
ing of accounting symbols. 5 For example, the symbol net income may 
represent to the accountant the difference between revenues realized 
and expenses incurred during an accounting period. If a foreign reader 
thinks the symbol indicates the difference between a firm's cash receipts 
and disbursements, the communication will be defective. The image 
in the mind of the accountant will not be transmitted to the foreign 
reader. 

A more subtle communication problem occurs when a given symbol 
may assume different meanings in different cultural contexts. For ex- 
ample, dividend payments may be discretionary in one country but 
obligatory in another, or they may be paid from consolidated versus 
parent-company earnings. The financial significance of the term divi- 
dends will, therefore, vary between cultures even if the dividend rate 
is identical in both. 

Differences in measurement rules also affect the meaning of ac- 
counting symbols. Thus, equipment valued at current replacement 
cost does not have the same meaning as equipment valued at original 
acquisition cost. Similarly, accrued taxes that do not consider tax defer- 
rals are not the same as accrued taxes that do. Different language 
and currency denominations have the potential to distort transnational 
communications as well. 

The extent of reader confusion owing to variations in the interpre- 
tation of accounting symbols is potentially greater internationally than 
it is domestically. In the latter case, mutual understanding by both 
preparers and consumers of accounting information of the "ground 
rules" of measurement and interpretation helps to minimize communi- 
cation distortions. 

THE PRIMARY-SECONDARY REPORTING PROPOSAL 

To help a reporting entity better meet its transnational reporting ob- 
5 Ibid., p. 45. 



86 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ligations, the Accountants International Study Group recommends that 
two kinds of financial statements be recognized as part of a country's 
official set of generally accepted accounting principles. Primary finan- 
cial statements would be prepared for a reporting company's domestic 
readers. They would reflect the accounting and auditing standards of 
the reporting company's country of domicile and be expressed in the 
language and currency of that country, for example, a U.S. company's 
traditional annual report is provided to its U.S. shareholders. Secondary 
financial statements would be prepared specifically for financial re- 
porting audiences of interest in other countries. These statements would 
reflect a combination of the accounting and auditing standards of the 
foreign country, as well as the language and currency of that country. 
Thus, a U.S. company with a major shareholder group domiciled in 
France would restate its domestic statements from American to French 
accounting principles. The statements would also be translated from 
U.S. dollars to French francs and from the English to the French lan- 
guage. Moreover, the auditor's opinion appearing on the secondary 
statements would be expressed in relation to French auditing and ac- 
counting norms. 

One proported advantage of the primary-secondary reporting sys- 
tem is that it accommodates more than a single set of accounting and 
reporting standards. In doing so, full recognition is afforded different 
national viewpoints. Another advantage is that accommodating reader 
audiences through multiple sets of financial reports increases the in- 
formation content and quality of primary-secondary statements thereby 
improving the transnational communication of financial data. Tailor- 
ing published corporate reports to specific readership groups also re- 
duces the generalized nature of traditional reporting formats resulting 
in information that is more relevant to user decisions. 6 

A CROSS-CULTURAL ANALYSIS OF PRIMARY-SECONDARY REPORTING 

Advantages associated with the AISG proposal make it intuitively 
appealing. But are these advantages more apparent than real? Specifi- 
cally, do primary-secondary disclosures really improve the communica- 
tion of financial information to foreign audiences of interest and, there- 
fore, lead to better financial decisions than would otherwise be the 

6 For additional advantages, see Frederick D. S. Choi and Gerhard G. Mueller, 
An Introduction to Multinational Accounting (Englewood Cliffs, N.J. : Prentice- 
Hall, Inc., 1978), p. 120. 



Primary-Secondary Reporting 87 



case? The question is important in view of the relationship between 
financial disclosure and capital market efficiency. 7 

To answer the foregoing question, the primary and secondary finan- 
cial statements of a Japanese company are examined in terms of tra- 
ditional financial ratio analysis. 8 The objective is to assess the risk and 
return features of this company relative to a U.S. counterpart before 
and after the Japanese statements have been adjusted to reflect U.S. 
accounting and auditing standards. 

Japan offers a suitable test environment in that many Japanese 
companies, having attained sufficient size and stature, are interested 
in raising funds in the U.S. capital market. 9 Perceived advantages of 
U.S. access include increased supply and diversification of loanable 
funds, lowered capital costs, and corporate prestige. 10 

As a condition for listing their shares on the major U.S. securities 
exchanges, foreign companies must conform to the financial reporting 
requirements of the United States Securities and Exchange Commission 
(SEC). In seeking comparability in financial statements issued to U.S. 
investors, the SEC permits, with certain exceptions, foreign issuers to 
prepare their financial statements in accordance with accounting 
principles generally accepted in their home country. Any material 
differences between the foreign and U.S. generally accepted accounting 
principles (GAAP) must be reconciled by way of footnotes to U.S. 
GAAP. In the case of Japanese companies, however, the commission 
has uniformly required that consolidated financial statements be pre- 
pared according to the GAAP of the United States. It is felt that 
Japanese financial statements are too vastly different from U.S. finan- 
cial statements to merit special treatment. 11 Japanese restatements 

7 See Frederick D. S. Choi, "Financial Disclosure in Relation to a Firm's Capital 
Costs," Accounting and Business Research (Autumn 1973) : 272-82. 

8 Ratio analysis is not without its limitations. However, limitations notwith- 
standing, financial ratios remain an integral feature of security analysis espec- 
ially among the less sophisticated who are apt to be the major users of secondary 
statements. 

9 Japanese companies whose shares have been admitted to listing on the New 
York Stock Exchange include Kubota Ltd. ; Matsushita Electric Industrial Co., 
Ltd.; Pioneer Electronic Corporation; and Sony Corporation. A half dozen 
others are currendy listed on the American Stock Exchange. 

10 Based on personal in-depth interviews with corporate financial executives, pro- 
fessional accountants, and government officials in Japan, September and Novem- 
ber 1979. 

u Proceedings, Securities and Exchange Commission Major Issues Conference 
(Washington, D.C.: SEC, 1977), p. 3. 



THE INTERNATIONAL JOURNAL OF ACCOUNTING 



must now be expressed in the English language, and translation into 
U.S. dollars using a convenient rate is permitted. 12 In effect, the SEC 
has mandated that Japanese companies prepare secondary statements 
as a condition for U.S. listing on the premise that such statements are 
more able to meet the information needs of U.S. investors. 

From a U.S. investor's perspective, Japanese security investments 
are attractive since Japan currently boasts a healthy economy as well 
as a strong currency. In recent years, the performance of the Japanese 
stock market has been very impressive relative to that of the U.S. and 
other national stock exchanges as can be seen in exhibit 1 . 

It has been shown that substantial advantages in risk reduction can 
be attained through portfolio diversification in foreign securities as 
well as in domestic common stocks. 13 As the correlation of returns and 
market risks between the Japanese and U.S. market are very low, 14 
the inclusion of Japanese securities in U.S. investment portfolios offers 
attractive opportunities for reducing portfolio risk. Moreover, by in- 
creasing the supply of financial instruments in the United States, Japa- 
nese issuers make possible a larger number of internationally diversified 
portfolios than would otherwise be the case. 15 

Data underlying the comparative ratio analysis appear in the appen- 
dices to this paper. Appendix 1 illustrates the secondary financial state- 
ments of the Hitachi Company, a large manufacturer of electrical, 
electronic, and communications equipment. 16 These statements are pre- 
pared according to U.S. generally accepted accounting principles and 
are consolidated. 17 



" "U.S. Rules Are Changed on Foreign Stocks," Asian Wall Street Journal, 12 
February 1980, p. 2. 

13 Bruno H. Solnik, "Why Not Diversify Internationally Rather Than Domesti- 
cally?" Financial Analysts Journal (July-August 1974) : 48-54. 
" The Nomura Securities Co., Ltd., International Diversification: A Case for 
Japan (Tokyo: Nomura Securities, 1979), p. 5. 

15 Additional advantages are discussed in Frederick D. S. Choi and Arthur I. 
Stonehill, "Foreign Access to U.S. Capital Markets: Theory, Myth, and Reality," 
Proceedings, Annual Meeting of the Academy of International Business (New 
Orleans, forthcoming). 

" The company was selected randomly from a list of companies identified by the 
Institutional Research and Advisory Department of the Nomura Securities 
Company, Inc., as being the most likely candidates to raise funds in the United 
States. The author wishes especially to acknowledge the kind assistance of Mr. 
Hisaaki Hino and Mr. Junichi Ujiie for securing the primary statements and 
arranging for their translation to English. 

17 Hitachi's primary financial statements in the Japanese language and de- 
nominated in Japanese yen are available from the author upon request. 



Primary-Secondary Reporting 89 



Exhibit 1. Market Performance Comparison* 



8-year Compound Growth Rate (%) 




1970 1971 1972 1973 1974 1975 1976 1977 1978 

Market indexes with 1970 as the base year. (100) currency fluctuation adjusted. 



90 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Exhibit 2. Risk and Return Ratios: Hitachi vs. General Electric 



Financial ratios 

Liquidity: 
Current ratio 
Quick ratio 
Inventor) - turnover 
Average collection period 

Solvency: 
Debt ratio (%) 
Times interest earned 

Profitability : 

Return on total assets (%) 

Return on 

stockholders' equity (%) 



Hitachi 
(Primary F/S) 

1.2 times 
.87 times 

4.1 times 
86 days 



76 
2.2 times 

2.5 
10.5 



General Electric 
(Primary F/S) 

1.4 times 
.93 times 

6.5 times 
61 days 



55 
6.4 times 

8.1 
18.6 



The contents of exhibit 2 suggest that G.E. is by far the better in- 
vestment candidate. Viewed from the eyes of a potential U.S. investor, 
Hitachi's liquidity, solvency, and profitability ratios are dominated by 
those of its U.S. counterpart. But is this a valid comparison? Propo- 
nents of the primary-secondary reporting system would argue it is not 
as Hitachi's statements mirror Japanese rather than American account- 
ing principles. This potential "apples versus oranges" problem is a 
genuine concern if Japanese accounting norms differ significantly from 
those in the United States. That this is indeed the case is suggested by 
an examination of the relevant literature. 18 

While accounting and reporting practices in Japan are theoretically 
influenced by a variety of forces, including Japan's Commercial Code 
and Securities and Exchange Law, reporting entities have largely opted 
for tax-oriented accounting and disclosure. This practice is explained 
by the legal requirement that an expense cannot be deducted for tax 
purposes unless it is also deducted for book purposes. Accordingly, 
expenditures such as research and development and organizational 
costs are rarely capitalized. Depreciation expenses generally reflect 

18 Robert J. Ballon, Iwao Tomita, and Hajime Usami, Financial Reporting in 
Japan (Tokyo: Kodansha International Ltd., 1976), pp. 183-286; M. Edgar 
Barrett, Lee N. Price, and Judith Ann Gehrke, "Japan: Some Background for 
Security Analysts," Financial Analysts Journal (March-April 1974) ; John M. 
Crawford, "Accounting Considerations for Japanese Issuers in the United 
States," Selected Papers (New York: Haskins & Sells, 1974); Coopers and 
Lybrand, Japan (New York: Coopers and Lybrand, 1977), pp. 40-50; and 
Price Waterhouse International, International Survey of Accounting Principles 
and Reporting Practices (London: Price Waterhouse International, 1979). 



Primary-Secondary Reporting 91 



accelerated as opposed to straight-line cost allocations while intangibles 
tend to be amortized over short-term horizons as compared with U.S. 
practice. This bias toward tax accounting principles also means that 
accounting for deferred taxes, owing to timing differences between 
book and tax reporting in revenue and expense recognition, is seldom, 
if ever, practiced. 

A number of tax-saving reserves are also available to Japanese com- 
panies as a means of tax deferral. Special purpose reserves are an ex- 
ample of government sanctioned charges against current taxable in- 
come to encourage commercial activities deemed in the national in- 
terest. Although these reserves must subsequently be restored to in- 
come in a future period, the initial tax savings, generated by under- 
stating taxable income, operate as an interest-free loan to the report- 
ing company from the government. Thus, corporations with stated 
capital of less than ¥100 billion may set aside 0.9 to 2.3 percent of 
total export revenues in an "overseas market development reserve" to 
be amortized within five years. To encourage foreign operations, be- 
tween 30 and 100 percent of qualified overseas investments may also 
be provided for in a reserve for possible losses. These reserves, if per- 
mitted, would generally be considered part of owners' equity in the 
United States. In Japan, they are recorded as liabilities. General pur- 
pose reserves, available to a much broader cross section of Japanese 
entities, also offer tax advantages. Reserves for bad debts may be estab- 
lished far in excess of that justified by a firm's actual collection experi- 
ence. With advance permission of the tax authorities, a reserve may be 
established for amounts due from companies in severe financial diffi- 
culties. Normally, this reserve is limited to 50 percent of such receiv- 
ables, but under certain conditions, it may be as high as 100 percent. 
A certain percent of total inventory value may also be charged to cur- 
rent operations and carried in an "inventory price fluctuation" reserve. 
Although the amounts so established must be reversed in the following 
period, the price fluctuation reserve can be calculated again at that 
time. 

Major differences between Japanese and U.S. accounting principles 
also relate to accounting for intercorporate investments. Thus, the 
preparation of consolidated financial statements, taken for granted by 
U.S. investors, is a rarity in Japan. Companies are often able to obscure 
or misrepresent parent-company earnings. This may be accomplished 
through the management of subsidiary dividends, or use of such devices 
as so-called special losses or profits, transfer of reserves between the 



92 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



parent and related affiliates, as well as well-timed sales of real estate 
or other assets between related group members. In fiscal periods be- 
ginning on or after April L, 1977, major companies in Japan are 
required by the Ministry of Finance to prepare consolidated financial 
statements. Despite this rule, however, many companies are reportedly 
circumventing the requirement by reducing their ownership interests 
in related subsidiaries below the 50 percent ownership criterion as a 
basis for consolidation. 19 

Whereas companies in the United States are required to account for 
nonconsolidated subsidiaries under the equity method, companies in 
Japan generally adhere to the cost method. Consequently, the only 
evidence of increases in the value of a company's intercorporate invest- 
ments is the amount of dividends received from affiliated companies. 
This understatement of intercorporate investments is compounded by 
the practice of stock rights offerings in Japan being recorded at par 
as opposed to current (higher) market values. 

As a final example of cross-national financial reporting variations, 
consider the level of corporate financial disclosure. The provision of 
comparative data, a generally accepted accounting principle in the 
United States, is not required in Japan as is disclosure of either ac- 
counting methods employed or changes in these methods. Any change 
approved by the tax authorities is accepted by the local community. 
and methods may be changed as often as tax authorities permit. De- 
pending on the company, explanations of accounting changes may vary 
from the complete absence of supplementary disclosures to lengthy ex- 
planatory footnotes. 

Exhibit 3 summarizes Hitachi's financial ratios based on its second- 
ary financial statements. These statements have been prepared in con- 
formity with U.S. accounting principles and have been audited by a 
major international CPA firm. Accordingly, the statements have been 
consolidated and employ the equity method of accounting for inter- 
corporate investments. Tax-related reserves have been reversed out 
and timing differences between book and tax reporting are reflected 
in deferred taxes. 

As a result of the statement translations, Hitachi's profitability ra- 
tios exhibit a definite improvement, although they are still lower than 
those of G.E. Hitachi's rate of return on total assets increases from 2.5 
to 3.1 percent, while its rate of return on stockholders' equity increases 

19 Japan's Accounting Shake-Up," Business Week (25 April 1977) : 150-51. 



Primary-Secondary Reporting 93 



Exhibit 3. Hitachi's Adjusted and Unadjusted Risk and Return Ratios 





Hitachi 


Hitachi 


Financial ratios 


(Primary statements) 


(Secondary statements) 


Liquidity : 






Current ratio 


1.2 times 


1.2 times 


Quick ratio 


.87 times 


.87 times 


Inventory turnover 


4.1 times 


3.5 times 


Average collection period 


86 days 


82 days 


Solvency : 






Debt ratio (%) 


76 


74 


Times interest earned 


2.2 times 


2.1 dmes 


Profitability : 






Return on total assets (%) 


2.5 


3.1 


Return on 






stockholders' equity ( % ) 


10.5 


11.6 



from 10.5 to 11.6 percent. However, while Hitachi's profitability ratios 
improve, its liquidity and solvency ratios remain essentially unchanged. 
Based on this analysis, a U.S. investor would have to conclude that 
General Electric is still the better choice as Hitachi appears no less 
risky than before. 

But is Hitachi really riskier, financially, than General Electric? It 
is not when analyzed from the perspective of the Japanese environ- 
ment. This environment, incidentally, is where Hitachi conducts the 
bulk of its transactions. It is also the environment in which the com- 
pany's financial transactions are perceived and symbolized for external 
reporting purposes. Proper evaluation of Hitachi's risk and return pro- 
file necessarily requires an awareness and understanding of business 
and financial mores in Japan. 20 

Consider, first, the question of financial leverage. Hitachi's ratio of 
total debt to total capitalization (debt ratio) of 74 percent appears 
alarmingly high when compared to G.E.'s 55 percent. 21 Viewed as a 
sign of impending bankruptcy in the United States, high debt ratios 
are not considered unusual by the Japanese owing to historical and 
postwar developments in Japan. When the Japanese government 

*" Information for this section is based on existing literature and in-depth inter- 
views conducted with corporate executives, professional accountants, and gov- 
ernment officials in Japan as part of a two-year research project concerning 
differences between U.S. and Japanese financial ratios. 

21 An expanded study in process suggests that the ratio differences observed 
between Hitachi and G.E. apply to the broader population of Japanese and 
U.S. companies as well. Frederick D. S. Choi et al., "International Ratio Analy- 
sis: Use and Misuse." 



94 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ended Japan's 200 years of international isolation over a century ago 
(the Meiji Restoration), it embodied rapid economic growth and de- 
velopment as a national goal. 22 To achieve this national obsession, the 
government established an extensive banking infrastructure to supply 
industry the bulk of its financial requirements. The reliance of indus- 
trial companies on the banking "establishment" was heightened during 
the aftermath of World War II with the need to rebuild a war-torn 
economy in the absence of viable financing alternatives. Large enter- 
prises evolved with major commercial banks constituting the core of 
the new industrial groupings. Related through commercial and personal 
ties, as opposed to majority stockholdings characteristic of prewar 
zaibatsu (large holding companies), the relationship between banks 
and related companies has become very close — so close, in fact, that 
a bank would seldom impose financial penalities on delayed debt repay- 
ments or call a delinquent loan. Instead, it would typically extend the 
terms of repayment and occasionally refinance the loan. The lending 
bank would even go so far as to install a bank official on the board of 
the troubled company to provide it with helpful managerial assistance. 23 
With interest and principal payments postponable, long-term debt 
in Japan assumes the feature of equity securities. 

Hitachi's interest coverage of 2.1 times also stands in marked con- 
trast to G.E.'s 6.4 figure. With a much smaller earnings buffer than its 
American counterpart, Hitachi theoretically runs a far greater risk of 
not being able to meet its periodic interest requirements. Again, with 
debt service payments postponable, the risk of default is more apparent 
than real. Drucker reinforces this point by offering a Japanese banker's 
perspective on the question of interest coverage. To quote him di- 
rectly, 

A Japanese business must earn enough money to pay the interest on what is 
legally a bank loan but economically is equity investment in business and in- 
dustry. The profit in the Japanese economy — the return on venture capital 
— is essentially the difference between what it costs a Japanese bank to 
attract and hold deposits, and the interest it charges for the loans to industry. 
Therefore, Japanese banks have traditionally kept interest rates on deposits 
exceedingly low. . . . The interest they charge their industrial customers, on the 
other hand, is rather high and runs at least one-third, if not one-half, above 
interest rates charged for truly commercial loans. ... As long as the interest 
on these loans is secure, the bank is satisfied. Business earnings over and above 

a Kamekichi Takahashi, The Rise and Development of Japan's Modern Econ- 
omy: The Basis jot Miraculous Growth (Tokyo: Jiji Press, 1969), p. 43. 
** In Japan, corporate directors actively engage in the management of enterprise 
affairs. 



Primary-Secondary Reporting 95 



what is needed to cover the interest charge with a fair safety margin are of no 
benefit to the bank. The bank's income is fixed, and therefore it exerts little 
pressure on its customers to increase earnings over and above the interest 
required. 24 

Institutional and cultural factors also cause liquidity ratios to differ 
without necessarily changing the basic financial risk characteristics be- 
ing measured. For example, Hitachi's lower current ratio, reflecting a 
large current debt position relative to current assets, signals a relatively 
weaker short-term debt-paying ability to an American reader. In Japan, 
however, a lower current ratio is seldom indicative of corporate illiquid- 
ity as short-term debt assumes a different meaning. From a company's 
perspective, short-term borrowing is attractive as interest rates on 
shorter maturity obligations are typically lower than those on long-term 
obligations. Moreover, short-term borrowings are seldom liquidated but 
are normally renewed or "rolled over." Banks are more than willing 
to renew such loans as it affords them an opportunity to adjust their 
interest charges to reflect changing market conditions. Consequently, 
short-term debt in Japan operates more like long-term debt. Indeed, 
while officially granted for working capital purposes, the use of 
short-term debt to finance long-term assets appears to be the rule 
rather than the exception in Japanese financial management policies. 

Longer average collection periods in Japan (eighty- two days for 
Hitachi versus sixty-one days for G.E.) also reflect differences in busi- 
ness customs. Purchases, for example, are rarely made for cash. In- 
stead, postdated checks with maturities ranging between sixty to 
ninety days are common. The Japanese tradition of lifetime employ- 
ment also influences, to some extent, collection policies. Companies will 
often go to great lengths to accommodate their commercial customers. 
During business downturns, repayment terms will be extended to avoid 
placing the buyer in a financial bind, thereby threatening an otherwise 
stable employment base. In return, continued patronage helps to as- 
sure employment stability for the selling enterprise. Lower inventory 
turnover statistics in Japan (see exhibits 2 and 3) are also affected 
by the lifetime employment tradition. During slack periods, manufac- 
turing companies prefer to continue production and accumulate in- 
ventories rather than idle workers. 

Adjusting Hitachi's primary financial statements to reflect U.S. 
generally accepted accounting principles eliminated the influence of 

21 Peter F. Drucker, "Economic Realities and Enterprise Strategies," in Modern 
Japanese Organization and Decision-Making, ed. Ezra Vogel (Berkeley: Univer- 
sity of California Press, 1975), p. 233. 



96 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



Japanese tax laws on its reported earnings. Despite the noted improve- 
ment, Hitachi's profitability ratios still did not exceed those of G.E. 
Would such lower profitability statistics raise the eyebrows of Japanese 
readers to the same extent as those of U.S. readers? They would not, 
as profits are viewed differently in Japan. 

The U.S. reader of an annual report tends to be an outsider and 
an individual or institution, such as a mutual fund, concerned with a 
company's short-term performance. The Japanese reader, in contrast, 
tends to be an insider, an institution, and one that is interested in main- 
taining an existing commercial relationship. Thus, corporate shares 
issued in Japan are largely held by commercial banks, trade suppliers, 
and corporate customers who tend to be members of the same indus- 
trial group or in the same industry. These shareholders, in turn, are 
not so much interested in stock market gains as they are in maintaining 
and strengthening their individual functional business ties. Corporate 
shares are accordingly held over long-term horizons. Under these cir- 
cumstances, short-term earnings statistics are of less concern than long- 
term results. 

Explanations as to differences in Japanese-U.S. financial ratios, 
such as those enumerated, are far from exhaustive. However, the point 
being made should be clear. Concluding that Hitachi is a poorer in- 
vestment candidate than G.E. on the basis of its accounting-based 
financial ratios is unwarranted. Proper interpretation of accounting 
signals and, therefore, effective communication of enterprise results 
across national boundaries cannot take place unless both message 
sender and receiver share a common understanding of the social, eco- 
nomic, and legal environment in which the message originates. 

CONCLUSION AND RECOMMENDATIONS 

Accounting has been described as a measurement and communication 
process. Since accounting measurements are based on business and 
financial transactions, whose nature is shaped by a given environment 
and since accounting measurement rules themselves are influenced by 
their environment, communication of differences in measurement rules 
alone, that is, differences in accounting principles, will not insure effec- 
tive communication with foreign audiences of interest. In our preced- 
ing analysis, translating the primary financial statements of a Japanese 
company to secondary reports consistent with U.S. accounting norms 
proved potentially misleading. Although designed to accommodate 
differing national viewpoints, secondary financial statements, as pres- 



Primary-Secondary Reporting 97 



ently construed, fail to recognize that a foreign reader's investment risks 
and rewards are highly dependent on the socioeconomic environment 
of the reporting company's country of domicile. The expected returns 
of a U.S. investor in Hitachi's common stock is ultimately a function 
of the performance of Hitachi's shares in the Japanese market, which 
is where the bulk of the company's shares are traded. Unfamiliarity 
with financial norms in Japan could very well result in a U.S. investor 
liquidating his Japanese investment in New York while his counter- 
part in Tokyo is behaving in just the opposite fashion, a less than 
desired state of affairs. 

This major shortcoming of the AISG proposal can be remedied by 
supplementing secondary financial statements with environmental dis- 
closures that assist foreign readers in properly interpreting these ac- 
counting reports. Disclosures as to common business and financial 
practices underlying reported accounting numbers will at least assure 
that signals transmitted by the secondary statements are interpreted 
within the proper environmental context. In terms of the measurement 
and communication process outlined earlier (namely, perception, sym- 
bolizing, analysis, and communication), supplementary environmental 
disclosures will help to assure that both the message sender and re- 
ceiver will share similar perceptions of the significant activities of the 
accounting entity. It is noteworthy that one of the five guidelines for 
the communication of accounting information recommended by the 
American Accounting Association's Statement of Basic Accounting 
Theory deals with the inclusion of environmental information. 25 

Should the foregoing proposal prove unacceptable, the only realis- 
tic alternative would be to regress to the status quo and disregard 
secondary reporting as presently envisioned. As before, readers would 
have to assume the primary burden of familiarizing themselves with 
the foreign environment in question — its culture, business practices, 
and financial mores — before making a foreign investment decision. 
These decisions, in turn, would have to be based on information con- 
tained in the reporting company's primary financial statements as op- 
posed to its secondary statements. The latter would then contain ac- 
counting measurement rules inappropriate to the environment of the 
reporting entity. 

Of the two options described, the former proposal is clearly prefer- 
able. After all, the function of international accounting is to provide 

15 American Accounting Association, A Statement of Basic Accounting Theory 
(Evanston, III.: AAA, 1966), p. 14. 



98 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



international decision makers with relevant information and to pro- 
vide that information at a lower cost to transnational readers than 
would otherwise be the case. In providing foreign readers with environ- 
mental information, accounting as an information speciality fulfills its 
dual role in the global community thereby retaining its sharp cutting 
edge of social usefulness. 



Primary-Secondary Reporting 99 



APPENDIX 1. Hitachi's Secondary Financial Statements 

HITACHI, LTD. and consolidated subsidiaries 
Consolidated Statements of Income 

Year ended March 31 

Yen~ U.S. Dollars 

(millions) (thousands) (note 2) 

1978 ~ ~977 1978 7977 

Net sales (note 5) ¥2,376,972 2,221,999 $10,'804,418 10,099,995 

Cost of sales (note 5) 1,746,344 1,645,405 7,937,927 7,479,114 

Gross profit ' 630,628 576,594 2,866,491 2,620,881 

Selling, general and ad- 
ministrative expenses 447,090 393,584 2,032,227 1,789,018 

Operating income 183,538 183,010 834,264 831,863 

Other income: 

Interest 47,141 45,274 214,277 205,791 

Dividends 3,553 2,800 16,150 12,727 

Other (note 5) 20,300 11,009 92,273 50,041 

70,994 59,083 322,700 268,559 

Other deductions: 

Interest 72,346 80,950 328,846 367,954 

Other 4,987 4,088 22,668 18,582 

77,333 85,038 351,514 386,536 

Income before 

income taxes 177,199 157,055 805,450 713,886 

Income taxes (note 7) : 

Current 94,953 89,421 431,604 406,459 

Deferred (4,470 ) (7,994 ) _ (20,318 ) (36,336 ; 

90,483 81,427 411,286 370,123 
Income before 

minority interests 86,716 75,628 394,164 343,763 

Minority interests 8,867 5,459 40,305 24,813 

Net income ¥ 77,849 70,169 $ 353,859 318,950 

Yen U.S. dollars (note 2) 

Net income per share of common stock: 

Assuming no dilution ¥ 30.07 27.29 $ 0.137 0.124 

Assuming full dilution. ... ¥ 28.55 25.85 $ 0.130 0.118 



100 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



HITACHI. LTD. and consolidated subsidiaries 
Consolidated Balance Sheets 

March 31 

Yen ' U.S. Dollars 

(millions) (thousands) (note 2) 

Assets 1978 7977 1978 1977 

Current assets: 

Cash ¥ 278,941 276,513 $1,267,913 1,256,877 

Marketable securities 

(notes 3 and 6) 248,970 191,037 1,131,682 868,350 

Trade receivables, net of 

allowance for doubtful 

accounts and unearned in- 
come — 1978¥20,356 mil- 
lion f $92,527,000); 1977 

¥18,132 million ($82,418,- 

000) (note 5) : 

Notes 171,576 166,361 779,891 756,186 

Accounts 362,349 373,091 1,647,041 1,695,868 

Inventories 492,477 511,112 2,238,532 2,323,237 

Prepaid expenses and other 

current assets (note 7) . . . . 102,991 104,822 468,141 476,464 

Total current assets.. .. 1,657,304 1,622.936 7,533,200 7.376,982 

Noncurrent receivables 

and restricted fund-? 

(note 4) 267,341 247,276 1,215,186 1,123,981 

Investments and advances, 

principally nonconsoli- 

dated subsidiaries and 

affiliated companies 

(notes 3 and 5) 168,756 152,046 767,073 691,118 

Property, plant and equipment 
(note 6) : 

Land 71,022 70,032 322,827 318,327 

Buildings 279,707 267,708 1,271,395 1,216,855 

Machinery and equipment 615.429 565,303 2,797,405 2,569,559 

Construction in progress . . 9,324 6,528 42,382 29,673 

975,482 909,571 4,434,009 4,134,414 
Less accumulated 
depreciation 550,399 503,439 2,501,814 2,288,359 

Net property, plant 

and equipment 425,083 406,132 1,932,195 1,846,055 

Other assets (note 7) " 24,975 20,482 113,523 ' 93,100 

¥2,543,459 2,448,872 $11,561,177 11,131,236 



Primary-Secondary Reporting 101 



March 31 

Yen U.S. Dollars 

(millions) (thousands) (note 2) 

1978 7977 1978 1977 

Liabilities and stockholders' equity 

Current liabilities: 
Short-term bank loans 

(note 6) ¥487,155 517,044 $2,214,341 2,350,200 

Current portion of long- 
term debt (note 6) 66,491 66,937 302,232 304,259 

Trade payables (note 5) : 

Notes 130,050 129,070 591,136 586,682 

Accounts 150,161 140,193 682,550 637,241 

Accrued expenses 128,721 123,031 585,095 559,232 

Income taxes (note 7). .. . 53,634 57,710 243,791 262,318 

Advances received 130,007 142,116 590,941 645,982 

Employees' deposits 94,796 90,496 430,891 411,345 

Other current liabilities. . . 91,436 68.367 415,618 310,759 

Total current liabilities. 1,332,451 1,334,964 6,056,595 6,068,018 

Long-term debt (note 6). . 311,498 321,106 1,415,900 1,459,573 
Retirement and severance 

benefits 137,204 1 18,055 623,655 536,614 

Minority interests: 

Capital stock 17,288 15,932 78,582 72,418 

Surplus 75,332 58,472 342,418 265,782 

Total minority interests. 92,620 74,404 421,000 338,200 

Stockholders' equity: 

Common stock of ¥50 par value. 

Authorized 10,000,000,000 

shares; issued 2,598,493,114 

shares in 1978 and 2,586,- 

211,962 shares in 1977 

(notes 6 and 8) 129,925 129,311 590,568 587,777 

Capital surplus 51,705 43,651 235,022 198,413 

Legal reserve (note 9) 31,212 29,102 141,873 132,282 

Retained earnings: 

Appropriated 56,839 54,697 258,359 248,623 

Unappropriated (notes 

6 and 9) 400,842 344.603 1,822,009 1,566,377 

670,523 601,364 ' 3,047,831 2,733,472 

Less cost of common stock 
held by consolidated sub- 
sidiaries, 5,555,646 shares 
in 1978 and 6,714,279 shares 
in 1977 837 1.021 3,804 4,641 

Total stockholders' 

equity 669,686 600,343 3,044,027 2,728,831 

Commitments and contin- 

gent liabilities (note 10). . ¥2,543,459 2,448,872 $11,561,177 11,131,236 



102 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



APPENDIX 2. G.E.'s Primary Financial Statements 



Statement of earnings 

General Electric Company and consolidated affiliates 

For the years ended December 3 1 (in millions) 1978 1977 

Sales of products and services to customers $19,653.8 $17,518.6 

Operating costs 

Employee compensation, including benefits 7,401.3 6,555.5 

Materials, supplies, services and other costs 9,866.7 8,753.9 

Depreciation, depledon and amortization 576.4 522.1 

Taxes, except those on income 250.6 239.0 

Increase in inventories during the year (399.1 ) (249.9) 

17,695.9 15,820.6 

Operating margin 1,957.9 1,698.0 

Other income 419.0 390.3 

Interest and other financial charges (224.4) ( 199.5) 

Earnings before income taxes and minority interest . 2,152.5 1,888.8 

Provision for income taxes (893.9) (773.1 ) 

Minority interest in earnings of consolidated affiliates (28.9) (27.5) 

Net earnings applicable to common stock $ 1,229.7 $ 1,088.2 

Earnings per common share (in dollars) $5.39 $4.79 

Dividends declared per common share (in dollars) . $2.50 $2.10 

Operating margin as a percentage of sales 10.0% 9.7% 

Net earnings as a percentage of sales 6.3% 6.2% 



Statement of financial position 

General Electric Company and consolidated affiliates 

At December 31 (in millions) 1978 1977 

Cash $ 1,992.8 $ 1,717.9 

Marketable securities 470.3 560.3 

Current receivables 3,288.5 2,982.7 

Inventories 3,003.4 2,604.3 

Current assets 8,755.0 7,865.2 

Property, plant and equipment 8,328.2 7,514.5 

Accumulated depreciation, depletion 

and amortization (4,305.6) (3,930.4 ) 

4,022.6 3,584.1 

Investments 1,410.5 1,433.3 

Other assets _ 847.9 814.2 

Total assets $15,036.0 $13,696.8 



Primary-Secondary Reporting 103 



Liabilities and equity 

Short-term borrowings $ 960.3 $ 772.1 

Accounts payable 1,217.2 1,021.4 

Progress collections and price adjustments accrued. . 1,667.3 1,369.7 

Dividends payable 147.6 125.1 

Taxes accrued 532.6 619.9 

Other costs and expenses accrued 1,650.2 1,508.8 

Current liabilities 6,175.2 5,417.0 

Long-term borrowings 993.8 1,284.3 

Other liabilities 1,129.5 921.2 

Total liabilities 8,298.5 7,622.5 

Minority interest in equity 

of consolidated affiliates 150.8 13 1 .4 

Preferred stock ($1 par value; 2,000,000 shares 

authorized; none issued) — — 

Common stock ($2.50 par value; 251,500,000 shares 
authorized; 231,463,949 shares issued 1978; 

231,410,196 shares issued 1977) 578.7 578.5 

Amounts received for stock in excess of par value .. . 658.0 668.4 

Retained earnings 5,522.4 4,862.5 

6,759.1 6,109.4 

Deduct common stock held in treasury (172.4) (166.5 ) 

Total share owners' equity 6,586.7 5,942.9 

Total liabilities and equity $15,036.0 $13,696.8 

Commitments and contingent liabilities 



104 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



APPENDIX 3. Choice of Financial Ratios 

The ratios selected for analysis should be the ones most frequently used by 
investors, security analysts, and bond rating services. The ratios used in Weston 
and Brigham, Essentials of Managerial Finance, 5th ed. (New York: Dryden 
Press), should suffice for this purpose. They are listed below. 

Measures of financial 
Current assets risk 

Current liabilities Used to analyze the 

r*, . . . . ability to meet short- 

Current assets — inventory ' ■, ,. 

-' run debt commit- 
ments. 



A. Liquidity 

1 ) Current 

2) Quick, or acid test 

B. Leverage 

3) Debt to total 

capitalization 

4) Times interest earned 

5) Fixed charge coverage 

C. Efficiency (activity) 

6) Inventory turnover 

7) Average collection 

period 

8) Fixed asset turnover 



9) Total operating 
assets turnover 



D. 10) Profitability 

11) Return on total assets 

12) Return on net worth 



Current liabilities 



Total debt (book value) 
Total assets (book value) 

EBIT 

Interest charges 

EBIT — Fixed charges 

Fixed charges 

Cost of goods sold 
Average inventory 

Receivables 



Sales per day 



Sales 



Fixed assets 



Sales 



Total operating assets 

Net profit after taxes 

Sales 

Net profit after taxes 

Total assets 

Net profit after taxes 
Net worth 



Used to analyze the 
ability to meet long- 
run debt and fixed 
charge commitments. 



Used to analyze the 
"staleness" of inven- 
tory. 

Used to analyze the 
"staleness" of receiv- 
ables. 

Used to analyze sales 
efficiency of plant 
and equipment. 

Used to analyze sales 
efficiency of total 
assets. 

Used to analyze com- 
petitive margins. 

Used to measure 
profit efficiency of 
total assets. 

Used to measure 
profit efficiency of 
stockholders' funds. 



Accounting for Joint Ventures with the Soviet 
Bloc and China 

RONALD E. HOYT and LAWRENCE D. MAPLES* 

INTRODUCTION 

The purpose of this paper is two-fold : first to examine the implications 
of accounting for "joint ventures" between U.S. firms and public-sector 
enterprises in the Soviet Bloc and China, and secondly to provide an 
analysis of tax implications for these types of ventures. 

The critical elements of accounting for joint ventures include the 
following items: (1) valuation standards for investments based on 
contractual relationships with foreign governments, (2) absence of con- 
vertible currency by which to measure international transfers between 
partners, (3) income- timing considerations, and (4) accounting stan- 
dards designed to fit market-type economies. 

CENTRAL ISSUES 

The first part of this paper addresses the question of appropriate con- 
solidation procedures for a Western firm engaged in contractual in- 
vestment in an Eastern Bloc country in three parts : ( 1 ) definition and 
description of contractual investment in East- West trade; (2) discus- 
sion of the criterion of significant influence for the case of joint ven- 
tures in the Soviet Bloc or China, and (3) evaluation of a Canadian 
alternative for joint-venture accounting. 

* Ronald E. Hoyt is professeur adjoint in accounting at the University of Laval, 

Canada. 

Lawrence D. Maples is assistant professor of accounting at the University of 

Louisville. 



106 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



The second part examines the effects which special conditions of a 
joint venture in an Eastern Bloc country have on tax liabilities of a 
U.S. firm. 

Contractual Investment Defined 

Contractual investment in East-West trade was described during the 
early 1970s by John B. Holt of the Fletcher School of Law and Diplo- 
macy, as a process by which Western firms and their Eastern partners 
engage in business activities normally known as direct investment, but 
with the unique feature that the relationship is based on a contractual 
instrument rather than ownership rights in the means of production. 1 
A contract is substituted for common stock in most cases, and in the 
cases where common stock is present, it is a device or surrogate for 
pro rata share of investment rather than residual ownership rights. 

Several aspects of the motivation for contractual investment must 
be understood if one is to appreciate the accounting problem involved. 
The first aspect touches the valuation models on which the two systems 
base their respective decisions. In the West, three major categories of 
valuation might be suggested as follows: 

1. Accounting values based on market-determined prices assuming 
segmentation in the markets 

a. entry values 

b. exit values; 

2. Accounting values based on market prices plus general price index 
adjustments; and 

3. Accounting values based on highly segmented market prices: ap- 
praisal values in real estate; rare art. 2 

In each case, the prices established in an exchange, said to be at arms' 
length, govern the accounting numbers to be recorded. In a command 
economy, by contrast, prices are determined arbitrarily as a function 
of government policies on items such as wages and services, and ma- 
terials used in production. 3 The subsequent derived prices which re- 
sult from a large input-output model of the industrial sectors are arbi- 
trary as well in the sense that these prices flow from social policy. 

1 John B. Holt, "New Rules for Western Multinationals in Eastern Europe," 
Columbia Journal of World Business (Fall 1973). 

1 See, for example, chapter 3 of Edgar O. Edwards and Philip W. Bell, The 
Theory and Measurement of Business Income (Berkeley: University of Cali- 
fornia Press, 1961 ) . 

* Robert W. Campbell, The Soviet-Type Economies: Performance and Evalua- 
tion, 3rd ed. (Boston: Houghton Mifflin, 1974). 



Accounting for Joint Ventures 107 



Transactions in the world marketplace which do involve external 
prices are also viewed in the context of an input-output model. Pro- 
fessor Holzman of Harvard University has suggested that the foreign 
trade inputs are those goods sold by the state to generate hard cur- 
rency. 4 The output of the process consists of goods purchased in foreign 
markets as gap fillers in the internal production process. Gain or loss 
on these transactions in aggregate for a Foreign Trade Organization 
(cost center) is a function of the internal prices for the aggregate sold 
and the aggregate bought. This, too, represents an extension of arbi- 
trary prices. 

From these brief comments, it is apparent that East-West trade 
takes place at the interface of two dramatically different systems of 
price structure. Joint ventures with Eastern partners involve not only 
radically different pricing techniques but different approaches to legal 
control and ownership rights as well. To further complicate matters, 
the international transactions of the joint enterprise take place without 
the convenience of convertible currency. An analysis of several hundred 
North American firms' experience dealing with the Eastern Bloc sug- 
gests the following arrangements classified according to consideration : s 

1. Cash (hard -currency transactions) ; 

2. Barter (quid pro quo exchanges of dissimilar goods) ; 

3. Countertrade (big ticket sales accompanied by self -liquidating debt 
involving dissimilar product) ; 

4. Parallel trade (a triangular or multiple party barter exchange) ; and 

5. Compensation (sale of plant and equipment accompanied by a 
buy-back agreement involving resultant product) . 

Although the transactions appear to be quite diverse, there are certain 
similarities that are important to understanding the process of trade. 
First of all, they are designed to circumvent, where possible, the ab- 
sence of convertibility and consequent shortage of hard currency. 
Secondly, these arrangements have an objective of avoiding pure debt. 
That is, cash transactions are used for small purchases such as specialty 
goods for the Berioska (hard-currency stores with areas limited to 
special goods and services) . Barter involves commodity-for-commodity 
exchanges, but countertrade and compensation involve self-liquidating 
credit arrangements enabling industrial equipment to be bought over 

4 Franklyn D. Holzman, Foreign Trade Under Central Planning (Cambridge: 
Harvard University Press, 1974), p. 321. 

'East-West Industrial Cooperation: The U.S. Perspective (Washington, D.G.: 
Bureau of East West Trade, U.S. Department of Commerce, May 1976). 



108 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



the long term with the assurance that goods, not hard currency, will 
be used to repay the debt. 

There are several methods of classifying the types of transactions 
involved in trade with the Eastern Bloc of China. The first is to group 
transactions by consideration exchanged as shown in exhibit 1. 

Exhibit 1. Transactions Determined by Consideration 

Transaction Consideration exchanged 

1. Monetary Hard currency 

2. Nonmonetary Barter 

Countertrade 
Parallel trade 

3. Mixed Compensation agreements 

A second classification method involves grouping exchanges by pur- 
pose, as suggested by Professor R. Lonstarienan, Helsinki School of 
Economics. 6 



Exhibit 2. Transactions Grouped by Purpose of Exchange 

1. Unilateral — One-way transfer of goods and services to Eastern Bloc 

2. Bilateral — Two-way transfer of goods and services to Eastern Bloc (in- 

dustrial cooperation) 

3. Triangular — Eastern Bloc partner and Western firm engage in joint proj- 

ects in third world countries 



Upon examining the motivations for these rather distinct groupings, 
it becomes apparent that unilateral trade (cash purchases) are stop- 
gap acquisitions to soften the impact of planning inadequacies. Bilat- 
eral exchanges involve longer-term considerations, in particular organi- 
zational development. The objective is improving organizational effec- 
tiveness through more sophisticated technology and better management 
techniques. 7 It is in this context that joint ventures (as defined in U.S. 
and Canadian accounting standards) play a role. The third category, 

* Comments provided during the discussion of a paper entitled "Models of East- 
West Trade" presented at the Academy of International Business Conference in 
Manchester, England, 22 November 1978. 

7 Ronald E. Hoyt and Lawrence D. Maples, "U.S. Taxation of Firms Engaged 
in East-West Compensation Agreements under the Doctrine of 'Open Trans- 
actions,' " Academy of International Business Conference Proceedings (Univer- 
sity of Hawaii, December 1979). 



Accounting for Joint Ventures 109 



cooperation in third countries, ostensibly involves economic develop- 
ment. 

The discussion to this point has served to differentiate the essence of 
a variety of exchanges from their form. It should be apparent that 
many transactions are similar to those present in market economies 
except for the type of consideration given in exchange. However, a 
certain number of very important transactions are longer term in na- 
ture and involve contractual arrangements by which the Western firm 
"invests" plant and equipment, and management services with a view to 
receiving payment in the resultant product of the enterprise, over a 
number of years and dependent on the success of the enterprise. The 
major categories of compensation agreements are presented in exhibit 
3. These definitions differentiate between different types of arrange- 
ments from a legal perspective. However, from an accounting view- 
point, it is along the lines of timing of income rather than the form 
of consideration that the boundaries should be drawn to separate 
sales from investment. 

Exhibit 3. Forms of Industrial Cooperation 

Joint ventures 

Three factors must be present for a venture : 

(a) At least two partners pool assets to form a new and distinct economic 
entity. 

(b) The partners agree to share profits and losses. 

(c) The partners jointly manage the enterprise. 

Co-production and specialization 

Both partners produce components for a final product to be assembled by one 
partner; technology is usually supplied by one partner; and there is usually an 
agreement to market the product in each partner's respective market. 

Subcontracting 

The socialist partner manufactures the product according to the Western 
partner's specifications and delivers the products to the Western partner. 

Licensing 

The Western firm licenses technology to the socialist partner and payment is 
made, not in the ordinary form of hard-currency royalties, but in products or 
components resulting from the use of the license. 

Turnkey plants 

The Western partner sells plant and equipment, and technology to a socialist 
partner and is paid in the products of the newly created plant. 

Source: James F. Pedersen, "Joint Ventures in the Soviet Union: A Legal and Economic 
Perspective," Harvard International Law Journal (Spring 1975) : 391. 



1 10 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



From an accounting standpoint, certain similarities exist between 
direct investment and contractual investment. Productive assets are 
transferred to a host country. Income is a function of the successful 
operation of the new enterprise at least (1) with respect to quality 
of output, and (2) with respect to consumer attitudes and tastes. 
Income is derived from product output rather than from cash pay- 
ments for the assets transferred. 

Therefore, the three major risk elements present in international 
investment are also present in contractual investment. These are 
( 1 ) country risk involving political and cultural characteristics relating 
to the national environment; (2) business risk associated with the 
financing, production, and marketing of the products in question; and 
(3) exchange risk arising from changes in the relative price levels of 
different economies which translate normally into currency-exchange 
gains or losses. 

There are certain peculiarities unique to contractual investment not 
present in direct foreign investment. The foreign firm is prohibited 
from owning an interest in productive facilities even by means of a 
host country intermediary. The firm has instead ownership rights to 
a share of the output of the joint enterprise plus certain management 
authority regarding quality control, engineering design, training of the 
labor force, and, in some cases, marketing networks. Secondly, power 
in an organizational sense flows from the state to the foreign firm 
through the contract rather than through a body of common law re- 
lating to property rights. 8 Thirdly, there is an absence of currency 
measures for valuation of individual transactions. Finally, there is a 
fundamental difference in the valuation bases used to price each part- 
ner's share of investment contributed to the joint enterprise. 

The Criterion of Significant Influence 

To encourage transfers of technology to their industries, a number of 
Eastern Bloc countries have created provision for the Western firms to 
form joint ventures, as described earlier. 9 The notable exception is the 
Soviet Union, but even there, contractual relationships enable long- 
term transfers of technology with repayment in resultant product. U.S. 

s James F. Pedersen, "Joint Ventures in the Soviet Union: A Legal and Eco- 
nomic Perspective," Harvard International Law Journal (Spring 1975) : 390- 
439. 

9 J. A. Burgess, "Direct Foreign Investment in Eastern Europe: Problems and 
Prospects for Romania's Joint Venture Legislation," Law and Policy in Inter- 
national Business (Fall 1974): 1059-1104. 



Accounting for Joint Ventures 111 



accounting recommendations pertinent to these relationships may be 
found in four sections of the Accounting Code published by the Amer- 
ican Institute of Certified Public Accountants: §1081, §2051, §4095, 
and §5131. The following brief summary is offered. 

Section 1081 dealing with foreign operations and foreign exchange 
suggests in par. 04 that U.S. companies show earnings from foreign 
operations in their own statements "only to the extent that funds have 
been received in the United States or unrestricted funds are available 
for transmission thereto." 

Paragraph 06 deals with foreign assets held abroad and their 
jeopardy, suggesting that 

especial care be taken in each case to make full disclosure in the financial 
statements of United States companies of the extent to which they include 
significant foreign items. 

Paragraph 08 and 09 treat methods of providing disclosure and 
consolidation of foreign subsidiaries. Paragraph 08 advises that 

. . . careful consideration should be given to the fundamental question of 
whether it is proper to consolidate the statements of foreign subsidiaries with 
statements of U.S. companies. 

Section 2051 deals with consolidated financial statements as set 
forth in ARB 43. Paragraph 03 states the general rule for consolidation 
is a controlling financial interest: "the usual condition (...) is own- 
ership of a majority voting interest." The exception to this rule cited 
in the same paragraph is the situation in which control is temporary. 
Paragraph 04 states a general principle for setting consolidation policy: 
"the aim should be to make the financial presentation which is most 
meaningful in the circumstances." 

Section 4095 deals generally with special areas of accounting for 
income taxes as set forth in APB 23. Paragraphs 15 through 18 focus 
on the special case of investments in joint ventures. 

Paragraph 15 reiterates the distinction set forth in Section 5131 of 
two types of joint ventures: (1) those which are permanent in dura- 
tion, and (2) those limited in life by the nature of the activity. Para- 
graph 16 suggests that a corporate joint venture may have "many of 
the characteristics of a subsidiary" supporting the conclusion of the 
board in Section 5131 that the equity method of accounting best en- 
ables an investor in a corporate joint venture "to recognize the under- 
lying nature of the investment regardless of duration." In par. 17, the 
board's opinion extends tax allocation procedures applicable to un- 
distributed earnings of subsidiaries to earnings of corporate joint ven- 



1 1 2 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



tures. Paragraph 18 reinforces the parallel treatment by requiring the 
same disclosure requirements as well. 

Section 5131 defines the general framework of the equity method 
of accounting for investments in common stock, as set forth in APB 
No. 18. Paragraph 01 of the introduction explicitly extends the appli- 
cability of the equity method "to investments in common stock of 
corporate joint ventures." Paragraph 03 defines "corporate joint ven- 
tures" as follows: "a corporation owned and operated by a small 
group of businesses as a separate and specific business or project for 
the mutual benefit of the members of the group." (Emphasis added) 

Examples of characteristics found in joint ventures are these: 

1. Sharing of risks and rewards in developing a new market, product, 
or technology; 

2. Combining complementary technological knowledge; and 

3. Pooling resources in development of production or other facilities. 

Additional characteristics of corporate joint ventures are these: (1) 
an arrangement for participation in management by each joint venturer 
is usually provided; (2) usually the interest of joint ventures goes be- 
yond passive investment; (3) ownership seldom changes; its stock is 
not traded publicly; and (4) a government may also be a member of 
the group. Paragraph 16 states the board's opinion that investors 
should use the equity method to account for investments in common 
stock of joint ventures both in their consolidated statements and in 
parent-company financial statements if they qualify as having "signifi- 
cant influence" as stated in par. 17 is the following: 

an investment (direct or indirect) of 20% or more of the voting stock of an 
investee should lead to a presumption that in the absence of evidence to the 
contrary an investor has the ability to exercise significant influence over an 
investee. 

This brief review of the major recommendations concerning account- 
ing treatment of joint ventures serves to underline three important 
elements of joint ventures in the East-West context: 

1. Many of the arrangements described in the first section do in fact 
fit the spirit, if not the letter, of these recommendations. 

2. In the political and economic context of E-W trade, it becomes 
apparent that although the criterion of significant influence for a par- 
ticular venture may be satisfied, other risks may require the use of the 
cost method for a reasonable presentation. 

3. Notwithstanding points 1 and 2, the fundamental differences in the 



Accounting for Joint Ventures 113 



two economic systems make the process of valuation of an entire busi- 
ness entity for purposes of presentation in the U.S. statements both an 
illegal act (from the Soviet perspective) and a highly unrealistic exer- 
cise since the investment itself can never be reclaimed or resold. 

The problems, therefore, in applying the current recommendations 
to situations described earlier as compensation arrangements and 
specifically joint ventures, arise because the analytical and cultural 
framework assumed in the recommendations is not the norm for East- 
West trade. First, the concept of a market economy and the rules 
for valuing assets and enterprises are absent. Fair presentation of the 
U.S. corporation's interests in a series of values arbitrarily set by the 
foreign government as its share of a joint venture is misleading and 
probably meaningless. 

Secondly, the accounting recommendations view stock as a con- 
tractual instrument representing ownership rights within the broad 
context of English common law tradition. In joint ventures for which 
separate corporations have been established, the stock represents a 
pro rata share of investment and rights to earnings but in no way 
suggests ownership of the underlying assets used in the means of 
production. The situation is similar in many ways to the present 
treatment of lease purchase agreements in the sense that the lessee en- 
joys the economic benefits of a productive asset and accounts for its 
consumption through depreciation in the process of creating revenues 
yet holds no legal title to the asset. In law it belongs to the lessor. Thus 
the accounting recommendations assume certain given facts in the 
relationship between use of productive resources for the generation of 
revenue and the legal basis on which an entity has the right to use 
these productive resources. 

A third problem which has several aspects is the test of significance 
(Sec. 5131, par. 17). One issue which is unresolved by the position of 
the board relates to the phrase "significant influence over an investee." 
In a very narrow sense, the investee is the joint venture entity. Many 
aspects of the joint venture are under very considerable control of the 
foreign company. For example, the foreign company may control engi- 
neering, technology, production standards, equipment used, training of 
employees, and marketing channels for part or all of the product sold 
abroad. This control resembles a controlling interest. However, the 
entity itself, though legally separate, is in practice grafted inseparably 
into the total political-economic structure of the country so that the 
investee is also in a larger sense the Ministry of Industry X or Y. No 



114 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



one would suggest that the U.S. firm exercised "significant influence" 
in this broader context. 

The investee is dominated by the ministry of its respective industry 
in several key areas. First, there is total control over the labor force. 
If the ministry wished to stop production, it could simply allocate the 
laborers elsewhere. Secondly, the supply of raw materials, their ship- 
ment, and their release across borders for sale abroad can all be con- 
trolled by the ministry in question. When, therefore, we speak of signif- 
icant influence, we must not lose sight of the degree of control in the 
environment external to the investee. While the U.S. firm may have a 
relatively free hand in the internal environment of the joint venture 
and under the rights given in the contractual relationship be capable 
of predicting with some degree of certainty the units of product it will 
receive for sale in its own markets, access to labor and materials are 
controlled totally by the state. 

If the equity method is conceptually inadequate for the case in 
point, it is not certain that the alternative/cost method represents a 
better solution. In brief, the cost method would seem to apply to 
situations of substantial political uncertainty for which it is uncertain 
that the U.S. firm will be able to benefit fully from its investment. The 
usual example which comes to mind is threat of expropriation by a 
foreign government. In these cases, the board simply recommends that 
U.S. firms show earnings "only to the extent that funds have been 
received" (Sec. 1081.04). 

One of the odd aspects of compensation agreements is the fact that 
the beginning of the transaction involves the transfer of plant and 
equipment from the U.S. firm to its Eastern partner in return for 
which a sum of money covering the majority or all of the cost of 
equipment is transferred from a bank to the U.S. firm. 10 

If the transaction were isolated at this stage, there would be a 
simple sale for which to account. But, in fact, there is a simultaneous 
and related contract by which the U.S. firm agrees to purchase an 
amount of product equivalent in value to the equipment sold or in 
some cases for substantially greater value during the life of the enter- 
prise. Within the framework of the package, the U.S. firm normally 
also has certain responsibilities for management services, production 
of subassemblies, and quality control. If one looks beyond the form of 

10 Jennell Matheson, Paul McCarthy, and Steven Flander, "Counter-trade 
Practices in Eastern Europe," East European Economies Post-Helsinki (Washing- 
ton, D.C.: Joint Economic Committee of Congress, 1977), pp. 1277-1311. 



Accounting for Joint Ventures 115 



the arrangement, it is clear that one is dealing with a joint enterprise 
not only in the case of joint ventures of the traditional type but also 
in many compensation packages classified under different titles. In 
these cases, although funds have in effect been received, a liability 
still exists under the associated contract and the question of timing 
comes into focus. 

The criterion of funds transfers thus does not portray the under- 
lying economic reality in East-West joint enterprises. Cash exchanged 
for goods may only be a case of capital cost recovery. A second reason 
which may be given for questioning the use of the cost method is the 
element of reasonable certainty associated with a contract with the 
state. Normally the cost method is used precisely for the reason that 
the host country conditions are unstable, and one is not certain of 
the security of one's investment. In contractual joint ventures, the 
opposite is presumed to be true. One is certain of the disposition of 
one's investment from the date the contract is signed. All of the normal 
features of business risk such as production problems, changes in mar- 
ket preferences, inflation, and so on, are still present, but one is cer- 
tain of the formula by which the investment will be repaid in product. 
This fact alone raises a serious question about the appropriateness of 
the cost method. 

From the foreign discussion, it seems clear that joint ventures in 
the command economies of the Eastern Bloc and China should not 
be accounted for by the equity method even in the case of significant 
influence over the internal affairs of the investee. By contrast, the cost 
method seems inadequate, first because it suggests uncertainty regard- 
ing the safety of the assets invested in the host country — an uncer- 
tainty that is unwarranted by the contractual framework described 
above. Secondly, there is a very real sense in which the U.S. firm en- 
gages in an investor relationship contributing its most valuable re- 
sources: technology, managerial skills, and marketing channels to the 
enterprise, along with the equipment transferred under the agreement. 

It seems appropriate, therefore, to consider other alternatives to joint 
venture accounting in view of the foregoing analysis. One such alter- 
native is the Canadian approach to joint venture accounting as set 
forth in the manual of the Canadian Institute of Chartered Accoun- 
tants. 

Canadian Alternative for Joint Venture Accounting 

Section 3055 of the CICA Manual defines joint ventures in the follow- 



116 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



ing terms: "A joint venture is an arrangement whereby two or more 
parties jointly control a specific business undertaking and contribute 
resources towards its accomplishment." (par. 03) 
Specific features of the joint venture include : 

1. Life limited to the duration of the undertaking, (par. 03) 

2. Relationship of the ventures is governed by an agreement usually 
in writing establishing joint control, (par. 04) 

3. Frequently formed for purpose of sharing risks and rewards in 
developing a new market, product, or technology, (par. 05) 

Guidelines given relative to accounting for joint ventures include 
the following three elements: (1) recognize income as earned rather 
than received, (2) match costs and revenues, and (3) handle trans- 
actions between the venture and the venturer appropriately. Three 
recommendations are given to cover various joint venture situations: 

par. 13 When earnings of a joint venture are unlikely to accrue to 

the venturer, the cost method should be used, 
par. 11 When a significant portion of the venturer's activities is car- 
ried out through joint ventures either the equity method or propor- 
tionate consolidation should be used, 
par. 1 1 Elsewhere the equity method should be used. 

The concept of proportionate consolidation involves the incorporation 
of the investor's pro rata share in the assets, liabilities, revenues, and 
expenses of the venture rather than a full consolidation as would be 
the case with a majority position in a subsidiary. For less than 51 per- 
cent ownership, the equity method shows a one-line consolidation 
whereas proportionate consolidation would add to the investor's state- 
ments the pro rata share of each asset, liability, revenue, or expense 
of the joint venture. 

In the case of joint ventures with the Eastern Bloc, the advantage 
of this type of approach would be on the one hand to enable the 
Western firm to acknowledge precisely its pro rata share in the total 
venture by showing its actual investment or the value of its pro rata 
share in market prices without complicated calculations to translate 
economic values at artificial exchange rates. In addition, it would re- 
flect the economic reality of an investment in a joint venture under 
contract with a foreign government. At present, the transactions are 
either passed through sales without reference to future commitments 
or are deferred until realization of revenue from the end products 
occurs or are simply omitted on grounds of lack of materiality. 



Accounting for Joint Ventures 117 



A second advantage of proportional consolidation based solely on 
investment values is avoidance of the definitional problems discussed 
earlier with respect to both the equity and cost methods. One escapes 
the control issue associated with the definition of significant influence 
by turning to the concept that none of the partners acts independently 
within the framework of the contract. This seems to represent fairly the 
situation described above. At the other side of the issue, one is no 
longer constrained to wait for repayment in product to provide infor- 
mation on an investment as the cost method would require. This op- 
tion is especially important when in fact a legal contract, presumably 
enforceable, exists assuring a certain estimable stream of earnings. 

A third comment on the suitability of a proportional consolidation 
method relates to disclosure. If one examines the disclosure require- 
ments for proportional consolidation, one finds precisely the kinds of 
information made available to the statement reader that would be 
necessary to evaluate East-West trade compensation agreements. As 
stated in par. 26(b), "... disclosure should be made in summary form 
of the venturer's share of the assets, liabilities, income and expenses 
of the venture" and in par. 30, "Disclosure should be made of con- 
tingencies and commitments of the venturer with respect to the joint 
ventures in which it has an investment." The disclosure of contingencies 
and commitments is a point of great importance in East- West trade, 
not only because of the different mix of risks described earlier, but 
also because the Western firm must look ahead as many as three to 
five years for product repayments to begin. It is very difficult in to- 
day's turbulent markets to do more than make a soft estimate of the 
present value of a stream of earnings from products expected to be 
received that far in the future, particularly for financial statement 
presentation. Yet without an appropriate method for valuing the firm's 
initial investment, a present-value figure would be the only alterna- 
tive for disclosure purposes. 

ENTITY CHARACTERIZATION FOR U.S. TAX PURPOSES 

The characterization of a particular joint venture as a corporation or 
partnership for tax purposes is a difficult subject in many instances. 
If a foreign entity is involved, the problems become greater. Partner- 
ship status may be more desirable if the objective is to pass through 
losses or to avoid the corporate level tax. Corporate status may be 
desired to shelter income. If the foreign venture qualifies as a corpora- 
tion under U.S. law, the income is not taxed to the U.S. stockholder 



118 THE INTERNATIONAL JOURNAL OF ACCOUNTING 



until it is distributed. Since U.S. tax is deferred and the tax situation 
in the Eastern Bloc is often negotiable, reinvestment in the new entity 
with before-tax dollars is possible. This arrangement can be of con- 
siderable aid in beginning a new business. 

There are some disadvantages to the corporate form. If earnings 
are distributed, they are taxed as dividends to the shareholder. If the 
shareholder is another corporation, the 85 percent dividends-received 
deduction is available, but the 15 percent is taxed twice. It is also pos- 
sible for a corporate shareholder to be pushed into personal holding 
company status because dividends are considered passive income. If 
the passive income threshold is reached, a penalty tax may be levied on 
the corporation. 11 If the corporate shareholder is a subchapter S corpo- 
ration, dividends could cause subchapter S status to be revoked. 12 

If the joint venture is in corporate form, liquidation will trigger 
taxable gains to the shareholders in the amount of the accumulated 
earnings. Capital gains treatment on these gains is normally available. 
Yet the tax is still a second tax on the earnings of the venture. 

If the joint venture sustains losses, the participants may deduct the 
losses currently if the partnership format is adopted. However, if the 
losing venture has corporate tax status, the losses sustained by the 
shareholders will be deferred until liquidation. In addition to the dis- 
advantage of loss deferral, liquidation losses are likely to be capital 
losses. There are limitations on the deductibility of capital losses. For 
individual shareholders, capital losses are deductible against ordinary 
income only to the extent of $3,000 per year. For corporations, capital 
losses in excess of capital gains may not be deducted. A carry-forward 
is available but may be used only against future capital gains. 

The preceding remarks demonstrate that either corporate or part- 
nership tax status may be desirable, depending upon the circumstances. 
Therefore, a discussion concerning the characteristics relevant in 
assessing the tax status of a joint venture is necessary. In the regula- 
tions, the Internal Revenue Service sets forth six characteristics it con- 
siders relevant in determining whether an entity is a corporation or 
partnership. These corporate characteristics are the following: associ- 
ates, an objective to carry on business and divide the gains therefrom, 
continuity of life, centralization of management, liability for corporate 
debts limited to corporate property, and free transferability of inter- 
ests. 13 



11 Sections 541-547, Internal Revenue Code. 

"Sections 1371-1378, Internal Revenue Code. 

11 Regs. Sec. 301.7701-2(a) (1), Internal Revenue Code. 



Accounting for Joint Ventures 119 



The presence or absence of each of these characteristics is to be 
considered in characterizing an entity. However, since the character- 
istics of associates and an objective to conduct